The Credit Spread Curve Distribution and Economic Fluctuations in Japan

Predicting the future economy is of great interest for practitioners and policymakers. This study challenges this problem by examining the relation between credit spread curves and future economic activity. To this end, we calculate the credit spreads of corporate bonds at the firm level to construct an empirical distribution of credit spread curves covering every month from April 2004 to March 2019. Then we examine which deciles of this empirical distribution have more predictive power for economic growth rates. Our results indicate that the credit spread curve information in higher-ranked deciles (implying lower credit quality) is the most useful and economically important for the business cycle. We also distinguish between two regimes according to credit spread uncertainty by employing a smooth-transition model to determine whether this uncertainty affects the predictive relationship between credit spread curves and the business cycle in Japan. Our results suggest that the predictive power of credit spread curves heavily depends on uncertainty in the corporate bond market. More specifically, our results demonstrate that the credit spread curves have more predictive power for economic growth rates under the low corporate bond market uncertainty regime.