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What to Make of a Contracting Leading Credit Index

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Understanding the Leading Credit Index

The Conference Board uses the credit conditions in the economy as one of the constituents of the Leading Economic Index (or LEI) economic model. This credit index is constructed by modeling changes to six financial market instruments. The changes to this index help us understand the state of credit conditions in the economy. The six components of the leading credit index are:

  1. Two-year Swap (SHY) Spread (real time)
  2. LIBOR 3-month (SCHO) less 3-month Treasury-Bill (VGSH) yield spread (real time)
  3. Debit balances at margin account at broker-dealer (monthly)
  4. AAII Investors Sentiment Bullish (%) less Bearish (%) (weekly)
  5. Senior Loan Officers C&I loan survey – Bank tightening Credit to Large and Medium Firms (IWM) (quarterly)
  6. Security Repurchases (GOVT) (quarterly) from the Total Finance-Liabilities section of Federal Reserve’s flow of fund report.
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Performance of the Leading Credit Index in March

In March, the Leading Credit Index recorded a reading of -0.46, declining, compared to the February reading of -0.79. This is an inverse index where a lower value reflects better credit conditions. The decrease in the leading credit index is a sign that financial conditions could tighten soon.

A negative value of the leading credit index is considered to have a positive impact on the economy. The lower the value, the easier it is to obtain credit. This credit index has a weight of ~8.2% on the LEI and in the March LEI report, the Leading Credit Index had a net positive impact of 4.0% on the overall LEI improvement.

Credit conditions could be tightened further

The latest rate hike from the US fed has led to higher short-term rates and with the Fed signaling further rate hikes, it could be possible that credit conditions could get tighter. Declining credit conditions make it difficult for businesses to raise capital, which could eventually lead to a slowdown in economic activity. 

In the next part of this series, we’ll the scare from narrowing yield spreads in the bond markets.

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