Although the close relationship between credit spreads and economic activity has held most of the time since 1950, the late 1990s witnessed a significant decoupling. Companies expected long-term stable and high growth rates, driven by new technologies like internet and mobile communication.

Coupled with a sustained rise in profitability, an idea strongly promoted by the Fed, this expectation caused companies to invest heavily and to leverage their balance sheets. In this period maximization of shareholder value was the credo of many managers. Despite strong economic growth credit markets punished the rise of financial and operating leverage that was observable across most industries and companies with widening credit spreads. Excessively high default rates in 2001 and 2002 showed that market participants anticipated the rise in systematic risk quite early. The sustained equity downturn and cases of fraud added to the woes of the credit markets.

While liquidity risk is primarily a function of the willingness and ability of banks and brokers to provide liquidity and of investors’ readiness to take on risk, in other words, risk appetite, the other two points are related to the economic environment. The companies’ ability to generate sufficient cash flows to service their liabilities is central for the probability of default and is reflected in ratings. In general slowing economic growth, usually coupled with lower private consumption due to weak growth of labor income and rising unemployment undermines the profitability of the corporate sector.

In this context, it is worth remembering the definition of a recession. Market participants often define recessions in terms of two consecutive quarters of decline in real GDP. The National Bureau of Economic Research (NBER) which is responsible for dating recession periods, however, claims that recessions are characterized by a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production and wholesale–retail sales.