Thursday, May 26, 2016

Credit tightening as a leading indicator for recession

 - by New Deal democrat

I've written about several legitimate bearish concerns in the last couple of weeks.  First of all, the inventory to sales ratio is one that has frequently (but not always) been associated with recessions.  Secondly, transportation of all sorts is solidly negative YoY - even against poor comparisons.  Since goods have to be transported to market somehow, this confirms ongoing weakness -- not just of commodities, but to a lesser extent of finished goods as well.

A third legitimate bearish concern is credit tightening.  Unfortunately I failed to bookmark the article and I can't find it now, but recently several researchers (from a regional Fed?) published a paper suggesting that expansion and contraction of credit conditions tended to drive economic activity (iin the form of commerical loans) with a lead time of about 18 months.  Here's their graph:

One important limitation of this series is that there is less than 30 years of data, and 3 recessions.

This limited data sample does indeed suggest that net tightening of credit is a long leading indicator for recession (although note that we aren't yet at levels of tightening associated with the onset of either of the past 3 recessions).

But what drives tightening?  Is it an independent variable, or is it in turn driven by something else? Does it give us new information, or just confirm other information?

My suspicion is that credit tightening is a reaction to a decline in interest rate spreads, and a deceleration of corporate profits.  Banks make less profit on loans as the spread between short and long term interest rates decline, and as they see corporate profits stalling, it would be reasonable to take less risk.

And that is exactly what we see.  Here is the spread in yield between 2 and 10 year treasuries (blue) and credit largesse by banks (red, inverted):

A decline in yields between short and long term maturities has reliably led to a deceleration in the expansion of credit by banks, with a lag of between 12 to 24 months.

Here are corporate profits vs. credit tightening:

What we see is that the increase in credit loosening peaks before profits, but conversley an outright decline in corporate profits signals a net tightening (i.e., crossing from easing to tightening) in credit availability, usually with a short lag on the order of 1 quarter.

So credit availability does appear to be a leading indicator, but it may be mainly confirmatory of the yield curve and interrelated with corporate profits.