Key Economic Variables During the Credit Crisis
Using the credit cycle between 2001 and 2008 as an example, we examine key economic variables of the credit cycle and their relationship to credit spreads. (The charts below illustrate each of the four macro indicators during this credit cycle):
- Beginning of the Credit Cycle (2002-2003): In response to the U.S. recession in 2001, the Federal Reserve aggressively eased monetary policy, causing a rapid steepening in the yield curve which moved from an inverted position to a positive spread of 300bps between 10-year and 3-month bond yields. Such steepness lasted throughout 2002 and 2003, improving bank profitability and the supply of credit. Over this period, the corporate sector continued the deleveraging process that started at the end of the recession, further improving long-term corporate fundamentals. These conditions facilitated a rebound in economic activity and a steady easing in lending standards, as demonstrated by the ISM survey rebounding from the low 40s to the high 50s and the steady decline in the percent of loan officers reporting a tightening in lending standards, from 50% to -20%. Corporate credit spreads tightened rapidly between 2002 and 2003 from roughly 270 basis points down to 130 basis points.
- Mid-Cycle (2004 to mid-2007): With the economy on a stronger footing, the Federal Reserve began a gradual tightening process in 2004. Policy normalization led to a steady flattening of the yield curve; however, it remained upward sloping throughout 2004 and 2005, signaling that monetary policy was still accommodative. In fact, the economy continued to grow at a steady pace, as shown by the ISM survey, which, while slowing, remained well into expansionary territory (i.e., above 50) between 2004 and early 2007. Similarly, lending standards continued to ease over the same 3-year period, while the corporate sector began to re-leverage in mid-2005. Throughout this period, credit spreads remained in a broadly stable range between 130bps -180bps, offering an attractive “carry environment” with low volatility. However, by the end of this period monetary policy had become too restrictive, causing the yield curve to invert between July 2006 and May 2007. These were the first signs of new risks building in the credit cycle.
- End of the Credit Cycle (Mid-2007 to 2008): The prolonged inversion of the yield curve between July 2006 and May 2007 was an important indication of monetary policy being too tight. Given the long lag between policy and the real economy, lending standards began to tighten and economic activity to weaken substantially in the second half of 2007. In addition, debt-to-GDP continued to rise until early 2008, increasing the vulnerability of the corporate sector in the face of slowing growth and tightening lending standards. In the fall of 2007, credit spreads widened beyond the range that held in the previous three years, pricing in the deteriorating growth outlook, weaker balance sheets and tightening credit conditions. Credit markets continued to underperform over the course of 2008, culminating in the final sell-off in Q4-2008, caused by the bankruptcy of Lehman Brothers and the ensuing global financial crisis. Authorities around the world responded with unprecedented monetary and fiscal policy support, stabilizing confidence and planting the seeds of a new credit cycle that began in early 2009.
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