First-quarter flow of funds accounts released yesterday by the Federal Reserve show a further decline in non-financial companies' borrowing requirement, defined here as their "financing gap" – capital spending minus domestic retained earnings – plus share purchases net of issuance. The borrowing requirement is a leading indicator of credit spreads – see chart and previous post.

The borrowing requirement amounted to 1.5% of GDP in the first quarter, down from a high of 9.5% in the fourth quarter of 2007. In the late 1980s and early 2000s, borrowing peaked eight quarters before the high-yield spread over Treasuries. Credit has rallied much earlier in this cycle, possibly because spreads reached more extreme levels in late 2008 than in the prior two bear markets. The historical two-year lead suggests that further significant spread compression could be delayed until 2010.

At 1.5% of GDP, the first-quarter borrowing requirement was below its average of 2.3% since 1985. The further fall last quarter mainly reflected a large cut in capital spending as companies slashed fixed investment and ran down stocks. A decline in net share buying also contributed, while firms offset profits weakness by reducing dividends, resulting in stable retained earnings.

Looking forward, an end to destocking should contribute to a significant rebound in capital spending over the remainder of 2009. The impact on the borrowing requirement, however, may be offset by a recovery in profits as economic growth resumes and a further fall in net share purchases, with companies using the opportunity provided by better markets to step up issuance.