Credit Spreads and Real Activity ∗

This paper explores the transmission of credit conditions into the real economy. Specifically, I examine the forecasting power of the term structure of credit spreads for future GDP growth. I find that the whole term structure of credit spreads has predictive power, even though the term structure of Treasury yields has none. Using a parsimonious macro-finance term structure model that captures the joint dynamics of GDP, inflation, Treasury yields and credit spreads, I decompose the spreads and identify what drives the relationship between credit spreads and the real economy. I show that there is a pure credit component orthogonal to macroeconomic information that accounts for a large part of the forecasting power of credit spreads. The macro factors themselves also contribute to the predictive power, especially for long maturity spreads. Taken together, credit and macro factors capture virtually all predictability inherent in the actual spreads, while additional factors affecting Treasury yields and credit spreads are irrelevant. The credit factor is highly correlated with the index of tighter loan standards, thus lending support to the existence of a transmission channel from borrowing conditions to the economy. JEL Classification: E43; E44; E47; G12.