Thank you, Mr. Chairman. I’ll be referring to the charts that were circulated just a little while ago. The top panel of the page 1 shows three-month U.S. dollar cash deposit rates, the libor fixing, and also the three-, six-, and nine-month forward deposit rates, from June 3 to September 20. Since your last meeting, three- month cash and forward rates traded in a narrow range as market participants reacted to mixed economic data. The three- and six-month forward rates continued to trade below the cash rate, suggesting that market participants were assigning some probability to a reduction in short-term rates, especially once the equity markets began to decline again after the early August bounce.
While short-dated deposit rates moved in a narrow range, Treasury yields fell, especially in the middle of the yield curve. As shown in the two middle panels on page 1, yields on Treasury issues have been falling for some time. The two-year note was yielding about 1.88 percent this morning, a new low for that security, with the latest decline in yield coinciding with the equity market sell-off. The most pronounced decline in yields since the middle of August occurred in the five- and ten- year areas. The five-year yield was at about 2.70 percent this morning, and the ten- year yield was at about 3.63 percent. The explanations for the sharp fall in yields are many, though none by itself is fully satisfying. Market participants have cited a weak economy, although interestingly most forecasts for third-quarter GDP were raised in recent weeks. Poor business sentiment was also cited, as were the corporate scandals, geopolitical concerns, and occasional rumors about problems at particular financial institutions.
However, since the biggest moves were in the middle of the curve, it would seem that mortgage hedging was in part the cause and in part an accelerator of the sharp downward move in yields. As interest rates declined since December, the volume of mortgage refinancing increased, prepayments shortened the duration of mortgage portfolios, and the quickest way for a portfolio manager to bring the portfolio duration into alignment was to buy noncallable Treasuries. Those typically are in the five- and ten-year sectors. An added factor in recent weeks has been the expectation by many market participants of increased hedging needs of Fannie Mae, which last week reported a duration gap of minus fourteen months compared with its target of plus or minus six months. Apparently many dealers and investors did some back-of the-envelope calculations and concluded that Fannie would need to buy a very large amount of Treasuries to close the gap. While there is no evidence that the government-sponsored entity conducted any such transactions in the Treasury market, those who cleverly thought they would front-run Fannie may have added to the buying wave. Not surprisingly in this kind of market, volatilities have been high. The mortgage hedging needs show up in volatility measures as well. The market for options on swaps is a key risk-management tool among investors in mortgage-backed securities. The bottom panel depicts the Mortgage Bankers Association refinancing index and the three-month option on a ten-year swap. Implied volatilities have risen to more than 30 percent along with the recent refinancing wave, as investors tried to stay ahead of the prepayment cycle.
Let me turn to the corporate market on page 2. During the summer the corporate bond market was one of reduced issuance, wider spreads relative to Treasuries, wider bid-offered spreads, and generally reduced liquidity, making it difficult for investors to adjust the risk in their portfolios. In the intermeeting period, the situation improved at the margin, but that improvement was from some very extreme conditions, and sentiment in this market remains very fragile. Spreads on investment- grade debt narrowed to about 225 basis points—still very wide but better than early August levels—as shown in the top panel. Issuance has also picked up, as you can see in the middle panel, though the markets have been very discriminating about which companies have had access. Conditions in the secondary market have improved since your last meeting. Liquidity is reportedly better. And the very wide bid-offered spreads reverted to more-normal levels in the week or two after the last meeting. The high-yield sector showed some signs of improvement in mid-August, as the equity markets rallied and the August 14 deadline for certification passed. But in September, issuance has been weak, and spreads again are beginning to widen. Finally, in the commercial paper market, there has been at least some stability at lower levels of issuance. I would note that one market that has continued to function well is the asset-backed market, including the market for asset-backed commercial paper. But even this development suggests that investors are demanding obligations that have an added dose of protection.
I think investors can be excused if they remain skittish—as one might expect after this year’s concerns about accounting, corporate governance, and reduced earning prospects—and if they feel a bit burned by the corporate market. The bottom panel graphs the monthly incremental return that an investor has earned from corporate bonds relative to Treasuries of the same duration. In the early to mid-1990s, the monthly incremental return was about 5 basis points, with a standard deviation of about 29 basis points. Since 1998 that incremental return has actually been minus 13 basis points—that is, the return on Treasuries has been higher—and the standard deviation has more than doubled. In short, investors who have concluded that the corporate market has high risks and low returns would not be out of bounds, at least based on the experience of the past four years or so.
Turning to page 3, Japanese equity markets have fluctuated widely as another fiscal period end approaches. In the run-up to March 31, almost six months ago, there was talk of a crisis in the banking system, given the decline in equity prices on the Nikkei to below 10,000. In response, the authorities imposed a series of rule changes on short sales, which triggered a sharp short covering rally. Last week the markets had to absorb a different surprise when the Bank of Japan announced that it would buy stocks directly from the banks. The announcement had a short-lived effect on the equity market, though bank stocks—the green line in the top panel—did bounce. The effect quickly dissipated since the market is waiting to see what else, if anything, will be done by the government to clean up the bad debt situation. Interestingly, the effect on the bond market so far has been more pronounced. The ten-year JGB yield, shown in the middle left panel, was heading toward 1 percent as gloom about Japan’s prospects built up. Over the past three trading sessions the yield shot up from about 1.03 to 1.30 percent, and this morning it was at about l.28 percent. The irony is that in the near term the announcement has not done very much for stocks but has adversely affected JGB prices, which itself is a major asset class for Japanese banks.
While the long end of the curve is backing up, the short end is in demand, at least for the time being, even at rates that are effectively or actually at zero. The Ministry of Finance’s Treasury bill and financing bill auctions have been stopping out at about 0.1 basis point. Now, you might think this would be an asset that would not be in much demand. But the bid-to-cover ratios in recent auctions have been about 700 to 1 or 800 to 1, and in fact, it appears that about half the accepted bids at recent auctions were at par. That is, investors were incurring the administrative cost to buy the bills at no return rather than take the credit risk of just leaving the money in a commercial bank.
As for the banks themselves, they, too, have a lot of cash looking for a home. The middle right panel shows the growth of deposits since the early 1990s and also the contraction of loans during that same period. With that much excess cash sloshing around the markets—and little in the way of investment opportunity—market participants expect the current environment to persist and, if anything, see more of the yield curve get pulled down toward zero. The bottom panel graphs the current yield curve, the solid red line, along with two other snapshots—from one year ago and from eighteen months ago before the Bank of Japan reverted to its zero interest rate policy. The current two-year yield is at about 5 basis points, and the middle of the curve is being tugged lower by the weight of all that cash looking for a home. As yet, however, this strategy has not helped to pull Japan out of its period of stagnation.
Turning to euro area markets briefly on page 4, the top panel graphs the three- month euro deposit libor rate, shown in black, and the three-month, six-month, and nine-month forward rates of that same three-month deposit. Those forward rates, which earlier this summer had been trading at a premium to the cash rate are now trading about 30 basis point below it, despite word from the ECB suggesting that it is very comfortable with the current stance of policy. In part the same set of economic and political factors that affected U.S. expectations are affecting euro area rates.
Forecasts for growth are receding quickly, a fact that has also been reflected in equity markets. European stock indexes have fallen sharply this summer. Since June 3, the Dow-Jones euro stocks index—a broad index of major companies in the euro area, represented by the solid red line—has fallen more than 30 percent, including declines yesterday and today. The sector that has been hit hardest and led the decline is the insurance sector—the dashed red line—which has seen its market value cut in half during that time. Europe’s insurance industry has been hit by losses not only related to the terrorist attacks, the floods in Europe, asbestos suits, and the like but also notably by the sharp drop in equity prices and losses in their credit portfolios. One question that has been asked over the past year or two, as the levels of defaults grew, was which balance sheets were absorbing these losses since few indications seemed to be popping up with banks and securities houses. Well, it has taken a while, but we finally seem to be getting some of the answer. Just for comparison, the U.S. insurance sector has also seen its shares clipped. The dashed blue line is the S&P insurance sub-index, which fell about 20 percent over that period, about the same as the broader index.
Following the pattern of the U.S. and other major markets, long-term bond yields in the euro area have declined as well. The yield on the ten-year bund to take one example—shown in the bottom panel—has fallen about 90 basis points since early June, including this morning’s price action. Given the weakness in major European economies, one might ask why yields, which are still nearly 65 basis points above comparable U.S. yields, did not drop even more. Part of the reason might be the outsized influence of the mortgage market in the United States, but part may also be related to concerns about backsliding on Stability Growth Pact targets by several of the major euro area governments.
Finally, let me say a word on reserves. The graph on page 5 shows the growth of currency over the past two years. During that period, currency grew mostly in a monthly range of 7 to 12 percent; through June the growth rate fluctuated around 10 percent, which was above longer-term trends. Since June, the monthly growth rate has fallen sharply into the low single digits and shows little sign of a turnaround. This has allowed the Desk to slow its outright purchases of Treasury securities and also to reduce the size of its long-term repo book from about $18 billion this spring to about $11 billion now.
Mr. Chairman, there were no foreign operations in this period. I will need a vote for approval of the domestic operations. And I’d be happy to answer any questions.