On the Information Flow from Credit Derivatives to the Macroeconomy

We investigate the information flow from credit default swap (CDS) spreads to macroeconomic activity in the United States and twelve European countries. We show that single-name CDS contracts across maturities and sectors provide significant information that anticipates future contractions. The more heavily traded 5-year maturity contracts and the iTraxx European/Markit North American CDS indexes show stronger results, indicating that these forward-looking and highly liquid instruments confer an economically and statistically significant financial signal for future economic activity. Focusing only on the most liquid CDS contracts, we then examine whether better liquidity in the CDS market is accompanied by a higher level of informed trading. A longer sample of US and previously unexplored European country-level data shows information flow intensifies as we approach credit events, and that the number of credit events provides a useful signal in itself of future economic downturns. Finally, we decompose the CDS premium into a liquidity and a residual component (proxying credit and other market risks), and find evidence that liquidity plays a greater role in explaining future macro outcomes over the sample period.