Thank you, Mr. Chairman. The intermeeting period began with
worries about building inflationary pressures but ended with a growth scare, as
incoming data were weaker than expected and Street economists fell over
themselves to cut their GDP forecasts for the first half of 2005. Meanwhile, the
inflation concerns remained, leaving traders and investors with a sense that the risks
The top panel on page 1 graphs the June and December 2005 Eurodollar deposit
futures contracts since mid-February. The December contract peaked around the
time of the March FOMC meeting, as the markets interpreted the Committee’s
statement as opening the way for a more aggressive pace of tightening. But that
view was short-lived as weaker retail sales, manufacturing survey data, and a
deteriorating trade situation all tempered what had been a more bullish growth
outlook. In short, the markets tinkered with the possibility of a more aggressive
tightening path but quickly fell back to the baseline scenario of 25 basis points per
That can also be seen in the middle panel on page 1, which shows the spread
between the 2-year Treasury note and the target fed funds rate. That spread contracted sharply at the start of the tightening cycle but then settled into a comfortable range of 80 to 85 basis points. In February and early March the spread widened to about 120 basis points as the probability of more aggressive tightening seemed to increase. But as the growth outlook began to be questioned in recent weeks, the spread reverted to about 80 basis points.
The bottom panel depicts the yield change in basis points of the 10-year Treasury note reset from the start of the tightening cycles of 1994, 1999, and the current one. Following the Chairman’s February testimony, 10-year Treasury yields rose to levels where they—arguably—were less of a conundrum. Alas, that also proved temporary as the fall in yields leaves them stuck in a corridor between 4 and 4½ percent. At 4.19 percent this morning, the 10-year yield is only a few basis points higher than in mid-February at the time of the Chairman’s testimony.
The next page takes a look at the yield curve and credit spreads. In the past year the search for yield, improved corporate and sovereign fundamentals, and the assurance the Fed was providing regarding the tightening path were common reasons cited for the flattening of the yield curve. As investors moved out the maturity curve, credit spreads narrowed and implied volatilities fell as market participants became more certain that monetary policy would not bring surprises. The past few weeks has seen a reversal, or at least a pause, in some of these trends.
One exception to this has been the behavior of the shape of the yield curve. The top panel graphs the 2- to 10-year spread, which flattened further in recent weeks. However, unlike the earlier flattening, this cannot be viewed as a period when investors were reaching for yield or when they were very complacent about the policy outlook. Nor is there evidence that central banks were unusually active. An alternative, though more unpleasant explanation, is that this sector of the bond market is signaling a further slowdown in activity.
Investment-grade corporate and emerging-market spreads both widened in recent weeks, as investors became somewhat more risk averse and reacted to some unexpected credit events. The recent widening of spreads in these two sectors can be seen on the right side of the page. However, this widening of spreads barely registers in the longer-term charts on the left side of the page. The optimist will look at this situation and be reassured that the markets are not overreacting to events and are still pricing in a fairly benign outlook. The pessimist will argue that the power of the cycle will continue to assert itself and that the period of spreads widening is just beginning, especially as the effects of previous tightening begin to be felt and corporate fundamentals shift from being in a period of improvement to a period of deterioration.
Speaking of deterioration, the top panel on the page 3 graphs the price of 5-year credit default swaps for GM, GMAC, and Ford since January 2004. The price of credit protection has more than tripled, mostly after GM’s earnings warning on March 16.
Meanwhile, spreads have widened, as shown in the middle panel. Although GM has more than $20 billion in cash on its balance sheet and the company is still investment-grade according to the rating agencies, it is a high-yield bond according to the markets. The blue line graphs the spread of a representative longer-term GM note. GM spreads are now wider than the BB and B indexes and closing in on the CCC index. Ford spreads are also trading like high-yield credits, though not as high as those of GM.
The news from GM appears to have had some chilling effects on issuance in the high-yield sector more generally, though the evidence is inconclusive. The bottom left panel shows the drop-off in high-yield issuance since the GM news. Of course, other events were going on at the same time, such as the changed tenor of the macro data and the fall in equity prices. Still, a plausible contributory explanation is that high-yield managers were unreceptive to taking on new paper with the prospect of a large migration of auto-related debt coming into their sector. One important question mark for portfolio managers is whether the troubles in the auto industry are sector-specific or whether the general period of improving corporate balance sheets is ending, to be followed by a period of higher financing costs, margin compression, and generalized credit deterioration.
The bottom right panel graphs the largest components of one high-yield bond index on a pro forma basis if GM were to be downgraded. Apparently GM would account for about 6 percent of this index. With GM spreads having already blown out, a downgrade may not have that much of an effect—on the theory that markets have already discounted the news. Of course, GM and GMAC are large issuers in the investment-grade sector, which is much larger than the high-yield sector. Therefore, we should not be surprised if there were some indigestion and a period of volatility, as a very large amount of paper is transferred from one set of holders with one set of time horizons and risk tolerances to another group with a different set of preferences.
As I mentioned earlier, implied volatilities were higher, although not in all asset classes. But they were higher for equities. The top panel of page 4 graphs the VIX index since January 2004. After reaching a low near 11 percent, the index shot up to about 19 percent during the recent period of equity price weakness. It has since settled back but in a choppy way. In fact, the volatility of the VIX—the second derivative—is as high as it has been during periods of more generalized market stress.
Fixed income and currency volatilities have been less exciting—in the middle and bottom part of the page—reflecting less anxiety relative to other indicators. I should note that dollar-yen volatilities rose on Friday when a brief flurry of excitement about a possible revaluation of the renminbi spilled over into dollar-yen and there was a temporary spike in implied volatility.
Finally, I want to return to a subject that was mentioned briefly at the last
meeting, namely, the appetite for longer-dated paper in Europe. As you will recall,
early in 2005 there was a mini frenzy about the need for pension fund managers to
“extend duration.” European issuers have been quite happy to step in and fill that
demand at pretty attractive levels. This is despite the watering down of the Stability
and Growth Pact and evidence that some countries showed creativity in managing
their financials to get into EMU [European Monetary Union] in the first place.
The top panel simply graphs the German and U.S. 30-year yields; German yields
have been consistently below those of the United States in 2005. Parenthetically I
do need to note that the last U.S. long bond was issued in 2001 so the U.S. 30-year
bond actually has a residual maturity of 26 years. While a 30-year Bund yield of just
under 4 percent could prompt one to ask what the German word for “conundrum” is
[laughter], there is no doubt that the environment has been favorable to issuers—and
not just for the most highly rated. As shown in the middle panel, spreads among
European sovereign issuers have converged over the last several years, just as
promised by the proponents of the Monetary Union. Among the higher-rated
issuers, France recently was able to issue a 50-year bond. At the other end, Greece
issued an attractively priced 30-year security.
The bottom panel graphs long-dated issuance—that is, beyond 10 years—for
euro area sovereigns since 2000. In 2000, all long dated issuance was by three
countries: Germany, Italy, and France. Through only the first four months of 2005,
such issuance has already exceeded that for the full year in every recent year except
2000. And most of the issuance is by countries other than the three I mentioned
Mr. Chairman, there were no foreign operations in the intermeeting period. I
will need a vote to approve domestic operations. And I also need to talk about