Leverage as a Predictor for Real Activity and Volatility

Abstract

This paper explores the link between the leverage of the US financial sector, of households and of non-financial businesses, and real activity. We document that leverage is negatively correlated with the future growth of real activity, and positively linked to the conditional volatility of future real activity and of equity returns. The joint information in sectoral leverage series is more relevant for predicting future real activity than the information contained in any individual leverage series. Using in-sample regressions and out-of sample forecasts, we show that the predictive power of leverage is roughly comparable to that of macro and financial variables commonly used by forecasters. Leverage information would not have allowed to predict the ‘Great Recession’ of 2008-2009 any better than conventional macro/financial predictors.

Keywords: financial crisis, forecasts, leverage, real activity, volatility

JEL Classification: C53, E32, E37, G20