Paul Mizen, University of Nottingham, “Using financial market signals to predict downturns in real economic activity”

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We provide new insights into the relationship between financial market tightness and real activity using a new database of corporate bonds issued in eight European countries. Bond spreads have a significant negative relationship with four real activity variables at horizons 1-8 quarters ahead. The relationship is robust to adding measures of monetary policy tightness and leading indicators, providing strong support for models previously only evaluated on US data. A sub-set of northern European countries have similar sensitivity of real GDP to bond spreads, but others have greater sensitivity to bond spreads, revealing diverse responses in Europe to financial market tightness. We also investigate the information flow from credit default swap spreads to macroeconomic activity in Europe and the United States. Single-name CDS contracts across maturities and sectors anticipate economic downturns, but the more liquid 5-year maturity contracts and Markit indexes show stronger results. The information flow from the CDS market intensifies with greater liquidity and becomes stronger around credit events, which also prove a useful signal of future downturns. Decomposing the CDS premium into liquidity and residual components we find the former plays a major role in explaining the rise in the CDS spreads with detrimental impact on future macroeconomic activity.