Economic Trends and Credit
Handorf, William C., Business Credit
Global, national and local economic trends affect credit demand and quality; credit factors also impact economic growth, employment, inflation, and the fiscal surplus or deficit of federal, state and local governments. Credit demand tends to decline in a weak economy. The repayment of credit previously extended often slows during and after a recession. By contrast, firms expand investment in working capital and plant & equipment as sales improve during initial economic recovery and later growth. In addition, the quality of credit recovers during economic expansion. Economic trends are important to the credit industry. Yet, it is difficult to forecast accurately whether and when the economy will recover, expand, slow or contract. This article reviews the recent empirical relationship between the economy and credit factors. We then demonstrate how credit managers can use readily available financial market data to forecast economic trends.
Economic Conditions and Credit Factors
As of mid-year 2004, the U.S. economy appears poised to expand after recovering slowly and unevenly from the last recession marked by the National Bureau of Economic Research between March and November 2001. Business and government had invested heavily in computers and software prior to Y2K. Equity investors bid up stock prices for companies within the technology sector and the promising dot.com component. The market euphoria ended early in 2001 and marked the end of the prior tenyear period of growth. Financial market relationships highlighted in this article were flashing signs of an impending recession six to nine months earlier.
Table 1 illustrates the annual dollar change in credit market instruments (i.e., commercial paper, corporate bonds, bank loans, etc.) and trade payables for non-financial business.The table shows the flow of funds and represents the dollar change in funding from one year to the next.A positive value indicates growth while a negative value indicates contraction. A less positive value than the prior year indicates growth at a slower or lesser pace.
* Industry has relied on the issuance of net new credit market instruments over each of the past five years. However, the rate of growth sharply declined in the recession year of 2001 and the year after as capacity utilization rates declined and working capital requirements fell. Interest rates often decline in a recession and many firms elected to replace short-term commercial paper and bank loans with long-term fixed-rate bonds.
* The impact of the recession is clearly visible when evaluating the importance of trade payables.Trade credit did not increase at a decreasing rate as shown for credit market instruments; trade credit plummeted in 2001 and expanded very little the year after as many firms had little reason to buy goods or services on credit given slack within many sectors of the economy.
There is normally a close positive relationship between economic trends and the demand for credit by business.
By historical standards, the recession of 2001 was shallow. The central bank aggressively engineered monetaiy accommodation by reducing the trading range of federal funds 13 times from 6.5 percent to just one percent. The federal government provided fiscal stimulus by increased spending on defense and homeland security, and reduced personal income tax obligations. The combined governmental actions provided a catalyst to jump-start the jobless recovery for much of 2002 and 2003.
Despite the relatively short and shallow recession, credit quality deteriorated. Table 2 illustrates the annual trend in the percentage of large bank loans that were charged off and other loans 90+ days slow in payment or placed in non-accrual status.
* Large banks with assets in excess of U.S. $10 billion incurred larger loan charge-offs and fewer recoveries in the recession year of 200!.The net loss shown in the table represents the loan losses net of recovery of loans previously charged off. Credit quality remained weak for the year subsequent to the recession.
* The proportion of large bank loans that were paying 90+ days slow and/or placed in non-accrual status also increased dramatically in the recession as debtors coped with rising unemployment rates, low capacity utilization rates and little consumer or business confidence in the future.
There is normally a close negative relationship between economic trends and credit quality.
Credit managers know all too well the relationship just illustrated between demand for credit, payment problems and economic trends. History is important; most managers are relatively more concerned about future prospects.There are several sources of information regarding the unknown outlook. First, credit managers can rely on economic experts to forecast the future. As we will show, short-term economic forecasts are approximately as reliable as one-week weather forecasts.
Two times each year, the Wall Street Journal invites approximately 60 economists and econometric firms to forecast six months later various factors, such as interest rates, currency values and so forth. Table 3 illustrates the average forecast of short-term interest rates by the experts prior to and after the last U.S. recession. For example, at the end of 1999, the experts forecast interest rates on three-month U.S. Treasury bills six months later would equal 5.6%; they actually reached 5.9%.The experts missed the recession of 2001. By year-end 2000, the experts forecast Treasury bills would yield 5.4% by mid-year 2001, which was far off from the 3.6% realized six months later. By the middle of the recession in 2001, the average expert forecast of 3.4% again proved far more optimistic than the 1.7% realized by the end of the year. The cumulative one year error projecting interest rates in the recession (and 9/11) equaled 3.5%.When interest rates average 5%, a 3.5% error cannot be considered trivial. Empirical studies of interest rates show1:
* Experts are reliable or good when there is little change in the market or interest rates.
* Experts miss the turning points of interest rates and the economy, which is critical to credit managers.
Although economic trends are critical to the credit industry, experts must be relied upon cautiously. Financial markets provide an alternate source of information to experts, and surveys similar to the Index of Leading Indicators compiled by the Conference Board.The data is published daily in the financial press.
Short-term money market interest rates respond to expectations of central bank monetary policy. The Federal Open Market Committee (FOMC) increases interest rates on the trading range of overnight federal funds when the central bank is concerned with excessively quick growth and/or accelerating inflation.The FOMC reduces the trading range of federal funds to stimulate borrowing and encourage consumer and business investment in durable goods and real estate. Long-term capital market interest rates, by contrast, reflect expectations of future monetary policy, the overall supply/demand for funds and inflation.The difference in selected interest rates also conveys information useful to a credit manager. A spread reflects the difference in yield between U.S. Treasuries of different term-to-maturity or the difference between the yield on a corporate bond and a U.S. Treasury instrument of comparable maturity. Interest rate spreads change in response to perceptions of the economy, default risk and tolerance for credit risk by investors and traders.
Two interest rate spread relationships, including the yield curve spread and the low-grade corporate bond credit spread, provide information that may be used to project future economic conditions, and confirm recently-released information about trends within the U.S. economy. Individual indicators may, and periodically do, provide false indications of economic strength or weakness. The composite spreads provide a representation of market expectations. Table 4 ( seepage 30) illustrates the trend for each of the key interest rate spreads two years prior to and after the recession of 2001.The table also includes similar information for mid-year 2004.
* Yield Curve Spread-The yield curve provides a graphical relationship between the yield and the remaining term of U.S.Treasury securities.The yield curve spread is defined as the difference in yield between ten-year U.S.Treasury notes and three-month U.S.Treasury bills.The slope of the yield curve partly reflects expectations of interest rates in the future.The yield curve is normally upward sloping because investors require higher yields for more risky, long-term debt. A more positive slope indicates the market expects interest rates to increase by a larger amount and/or rates will rise more quickly. Higher U.S.Treasury interest rates are consistent with projections of economic growth and/or accelerating inflation.A downward sloping yield curve indicates the market expects interest rates to decline given expectations of a recession, an accommodative monetary policy or price deflation. The yield curve spread has averaged 180 basis points over the past two decades.The yield curve spread was very low in 9 1999 as the market coped with repeated efforts by the FOMC to slow the then torrid pace of the economy and head off accelerating prices. It worked. Economic expansion soon turned to contraction.The yield curve spread turned negative in 2000 and early 2001, which was consistent with a high probability of a recession occurring within the next year. The yield curve spread increased to above-average levels in 2003 and is even higher mid-year 2004.The very steeply sloped yield curve is consistent with the expectation of increasing interest rates and a minimal chance of a recession during the next four quarters.2 Historically, there has been less than a 5 percent chance of a recession when the spread exceeds 1.20%, a 25 percent probability of a recession when the yield curve is flat, and a much higher likelihood of contraction when the yield curve spread is negative (e.g., 50 percent when the spread is -.80%).
* Low-grade Corporate Bond Credit Spread-The corporate credit spread reflects the difference in yield between corporate securities of comparable maturity but different asset quality. The low-grade corporate bond spread provides an especially good gauge of the market's perception of and tolerance for credit risk in the market.The yield spread between low-grade (e.g., BB, B and CCC credit ratings) and U.S.Treasury bonds widens when investors and traders seek safety from the consequence of default and loss given default more common during or just after a recession.
The credit spread narrows as investors reach for yield and are comfortable that debtors will pay interest and repay principal on a timely basis.The low-grade credit spread jumped from 4.6% in 1999 to a very wide 8.2% prior to the recession of 2001.The credit spread declined a little by 2003 as investors remained wary that the jobless recovery, lingering problems in the telecom sector and general unease with corporate governance would trigger additional credit problems. The low credit spread of 2.9% as of mid-year 2004 suggests that the market is comfortable with prospects for economic expansion.3
Overall, the financial markets reflect the perceptions of investors who have money-at-risk. Investors buy short-term and sell long-term securities if interest rates are projected to increase given economic expansion.The market activity will lead to a more steeply upward sloping yield curve. Investors will be willing to buy speculative low-grade corporate debt and sell default-free U.S.Treasury debt if the economy is projected to expand. The market activity will lead to a narrowing of the spread between the two securities. Both the more steeply sloped yield curve spread and the more narrow low-grade coiporate bond spread are transmitting the same message to credit managers.The U.S. economy will continue to expand during the next year. As new data is released about political, military, economic and financial issues, traders and investors quickly interpret and act. The market spreads can change quickly and convey updated information.
Business demand for credit changes with the economy. Firms require more funds when expanding working capital and/or investing in additional or more productive plant and equipment. Firms tend to pay credit more quickly and more fully when the economy expands. Credit managers can project the likely strength or weakness in the economy by focusing on two financial market spreads.The economy should improve or expand when the yield curve spread becomes more positive and the low-grade corporate credit spread narrows. The economy should grow more slowly and/or contract with a flatter yield curve spread or worse a negative yield curve spread, and a wider low-grade corporate credit spread. Credit managers have more confidence in the market when each spread conveys similar inferences.Although the market conveys useful information, it is not perfect. Financial market relationships complement traditional surveys, indices and expert economic forecasts.
The illustration below shows how credit managers can easily compute each of the above spreads. Or, interested readers may wish to use the author's monthly web site that updates these and other spreads of potential use to the credit manager. The market has proven to be at least as reliable as experts, and the cost is sharply less to access.There is no charge to use Global Indicators that is published eleven times each year on a monthly basis. [www.gwii.edu/~sbpm/news/indicators.htm]
1. Gosnell.Thomas F. and Robert W KoIb,Accuracy of International Interest Rate Forecasts, The Financial Review, (August, 1997).
2. Estrella,Arturo and Frederick S. Mishkin,The Yield Curve as a Predictor of U.S. Recessions, Current Issues in Economics and Finance published by the Federal Reserve Bank of New York, ( june, 1996).
3. Van Hornejames C.,Financial Market Rates and Flows, Chapter 8, (6th edition).
The author is a professor of finance with The George Washington University's School of Business located in Washington, DC. Dr. Handorf currently also serves as a director with the Federal Reserve Bank of Richmond's Baltimore Branch. he can be contacted at firstname.lastname@example.org.…
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Publication information: Article title: Economic Trends and Credit. Contributors: Handorf, William C. - Author. Magazine title: Business Credit. Volume: 106. Issue: 7 Publication date: July/August 2004. Page number: 26+. © 1999 National Association of Credit Management. Provided by ProQuest LLC. All Rights Reserved.