Monetary policy, too, appears to be an important indicator for corporate credit spreads. Let us assume that the economy is at the brink of deflation. Generally, deflation tends to be accompanied by a rise in bankruptcies. When corporate revenues and earnings are weak, highly leveraged borrowers have difficulties to meet their obligations. In this situation central bank easing paves the way for future economic growth. The traditional channels by which a lowering of the federal funds rate tends to stimulate faster growth in real and nominal GDP are: (1) lower debt cost of capital, (2) higher stock prices, (3) dollar weakness, (4) consumer durables, including automobiles, and (5) housing. Hence, it lowers the equity cost of capital and bolsters consumer confidence through the wealth effect. We see that  Baa credit spreads usually reach their peak when the Fed has done approximately two-thirds of the interest rate cuts.

Numerous empirical studies confirm that the economic cycle is an important determinant for the performance of credit and government bond markets. They find that credit spreads are negatively correlated with GDP growth.. Historically, spreads tightened during the early stages of economic expansions, and spreads widened during economic recessions. Crabbe and Fabozzi (2002) note that during the ten economic cycles since the end of the Second World War, the Baa–Aaa quality spread typically already widened in the months leading up to a recession. After a recession began, spreads usually continued to widen, peaking approximately 10–14 months into the cycle. The magnitude of the spread widening as well as the duration of the spread widening, however, varies from cycle to cycle, depending primarily on the duration of the recession period and the magnitude of the economic downturn. The fact that credit spreads tend to widen before the business cycle peaks indicates that corporate bond investors often anticipate future economic developments.

Focusing on macroeconomic activity variables, therefore, is not sufficient to predict changes in corporate bond spreads. Investors should carefully analyze leading economic indicators as well as any evidence that corporate profitability slows or leverage increases. Both factors result in a reduced ability to generate cash flows and weakens credit quality, resulting in a higher risk of default.