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.

Similar to the level of interest rates itself the slope of the yield curve also is an indicator for the economic environment. Generally, the slope of the yield curve is seen as a good proxy for future economic growth and corporate profits.

Steep yield curves imply that future rates are expected to be higher than at present. Asteep 2s10s slope and a further steepening of the 2s10s slope in the past often have been followed by positive excess returns of corporate bonds. Usually, one observes a steepness in this part of the curve at the end of a recession and at the start of an expansion. When the expansion finally materializes the curve flattens, and inflation concerns cause central banks to raise interest rates. In this environment, credit usually suffers, and investors should be particularly cautious when overweighting cyclical credits.