From what I’ve gathered in the readings:
Credit spreads narrow in expansions and widen in contractions.
Interest rate spreads narrow in contractions and widen in expansions.
Can someone explain that in simple terms (what’s happening and why)?
Credit spreads increase in contractions and decrease in expansions.
During expansion, companies are more profitable therefore the default risk on the financial assets (i.e: bonds, debt) are significantly lower comparing to during contractions when companies are facing losses. As a result, the difference between treasury securities (which are virtually default risk-free) and non-treasury securities is lower (lower credit spread) during expansion and higher during contraction (non-treasury securities face higher probability of default).
Interest rate spreads increase in expansions and decrease in contractions
Interest rate spread, from my understanding, is like a profit margin which measures the profitability of financial institutions. It is the difference between the rate the financial institutions charge on their loans and the rate they pay on their deposits and borrowings. The larger the spread, the more they make and hence the more profitable they are. That is why the spread is larger during expansion.
Perfect! Thanks.