Bond Spreads as Predictors of Economic Activity in Eight European Economies

Michael Bleaney, Paul Mizen and Veronica Veleanu

The global financial crisis that began in 2007 and the ensuing recession have spurred renewed interest in the relationship between tightness of financial markets and the business cycle. A number of papers have explored the relationship between corporate bond yields and real activity in the United States, where they find spreads have a significant negative relationship with real activity variables, see Gilchrist et al. (2009a), Gilchrist and Zakrajšek (2012) and Faust et al. (2013). While these papers provide convincing evidence that bond spreads predict future changes in real activity, there is no corresponding analysis for the Euro Area and the United Kingdom, which have the second and third largest bond markets respectively. This is mainly because these bond markets are comparatively young, but also because of a lack of country-specific bond indices. 

This Nottingham School of Economics working paper, recently published in The Economic Journal, constructs corporate bond indices for eight European countries, using the approach pioneered by Gilchrist et al. (2009a). This provides the first measures of corporate bond market tightness specific to each country, which can be used to explore hypotheses previously only tested on US data. The paper makes several contributions to the literature with potentially important policy implications for European economies. The first contribution is to show that bond spreads have significant predictive ability over macroeconomic variables for the largest European economies, providing a signal of incipient economic downturns in these countries. The authors evaluate the importance of the bond spread versus measures of domestic monetary policy tightness and leading indicators, as well as spillover effects from regionally or globally important economies and find that bond spreads offer a substantial contribution to the prediction of real activity. The second contribution is to exploit the cross-sectional dimension of our data to compare the responses to the bond spread measures in different countries across Europe. It is shown that the scale of the response is not equal, reflecting heterogeneity in the sensitivity of different European countries to financial conditions, measured by corporate bond spreads. Finally, the paper also decomposes the spread by removing the influence of default risk and bond characteristics before examining the information content in the residual (the "excess bond premium"). The authors show that the excess bond premium for each country in the euro area is correlated with the tightness of credit supply as reported in ECB surveys of bank lending. Furthermore, a lowering of bank credit supply has a significant negative correlation with future real GDP growth, whereas a lower level of credit demand from the same survey does not.

Forthcoming The Economic Journal, “Bond Spreads as Predictors of Economic Activity in Eight European Economies” by Michael Bleaney, Paul Mizen and Veronica Veleanu.

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