Thank you, Mr. Chairman. I’ll be referring to the charts that were
distributed a short while ago. The top panel of the first page shows the three-month
U.S. dollar libor fixing in black and the three-month deposit rates three, six, and nine
months forward in red. Forward rates had a minor roller coaster ride, first declining
immediately after your September meeting, rising in mid-October as equities bounced
off their October 9 lows, and then heading downward again as the economic data
were perceived as pointing to economic weakness. Although much of the decline in
forward rates had occurred by October 26, the day of the Washington Post article that
heightened expectations about a possible ease in policy, the article did strengthen
market participants’ convictions about the near-term direction of policy. The three-
and six-month forward rates both are now trading below cash rates. In the Treasury
market, the two-year note moved broadly in line with shifting expectations for official
policy. The yield fluctuated widely, going as low as 1.66 percent on October 9 and as
high as 2.22 percent around midmonth. The long end of the curve was affected by
many of the same factors as the short end, though the long sector once again was
probably affected by hedging of mortgage-backed securities (MBS) portfolios.
The middle panel graphs the ten-year yield in blue on the left scale and an
estimate of the duration of outstanding mortgage-backed securities—in red on the
right scale—since June. Many mortgages had been clustered in the 6½ percent
coupon bucket and, with rates falling, these mortgages became attractive to refinance.
Hence the estimated duration moved even lower from June to September. To hedge
against that shortening of duration, MBS investors could buy Treasuries or fixed
receiver swaps, either of which would have at least some impact on yield levels,
given the size of mortgage market. As that wave of hedging slowed, Treasury yields
suddenly jumped about 62 basis points in mid-October. Some investors, in fact,
reportedly overdid their hedging and in mid-October had to sell some of the positions
they had just bought. The other factor that had a day-to-day effect on yields—and
even an intraday effect at times—was the movement in equity markets. The bottom
panel shows one way of looking at this relationship. It graphs the 100-day rolling
correlation between the S&P 500 and the ten-year note yield since January 1988. I
would note two points. First, for much of this period the correlation was modestly negative, but in late 1997 it abruptly turned positive and, though choppy, has on balance remained positive. Second, the correlation, which was already high, has been increasing this year and is now higher than it was even during September 1998.
The intermeeting period continued to be difficult in the corporate bond market. Investment-grade spreads—shown in the top left panel on page 2—remained elevated, though they are off the peaks they reached a few weeks ago and also earlier this summer. Meanwhile, high-yield spreads—shown in the top right panel—topped 1,000 basis points in early October before easing very slightly. The only other time that index exceeded 1,000 basis points was in January 1991. Fixed-income investors, whether in investment-grade or high-yield securities—most of which are measured against the benchmark index—are in risk-averse mode, after having taken hits in many parts of their portfolios. Another way of looking at the corporate bond market is to take the investment-grade universe and divide the bonds into buckets according to their spread relative to Treasuries. The middle panel shows three snapshots of this—as of October 25 in 2000, 2001, and 2002. The percentage of the investment- grade universe trading at up to 100 basis points over Treasuries has been hovering at about 10 percent over these past couple of years. More than half of the investment- grade issues traded at a spread of between 100 and 200 basis points two years ago, as shown by the tall red bar. That category has now declined to about 40 percent, reflecting in part a migration of credit downwards. But perhaps the most striking development is the proportion of corporate bonds that are still investment grade but are trading at more than 400 basis points over Treasuries. From a small number earlier, that group now makes up one-fifth of the market, as you can see by the tall green bar on the far right.
That higher number reflects mostly the repricing of the debt obligations of some very large issuers, a phenomenon illustrated in the bottom panel. The panel depicts for the year 2002 to date the spreads on the fixed-income securities of four of the largest issuers. All four of these companies have seen a doubling or even tripling of their spreads at times. And while they are still investment grade in name, they are priced as if they were high yield. Because of their high and regular issuance, the bonds of these companies comprise meaningful chunks of mainstream fixed-income benchmark indexes and are widely owned. Now, I should note that not all large issuers have experienced a widening of their spreads. For example, Bank of America is trading at a spread of about 105 basis points, and Citigroup, despite negative publicity, is at about 115 basis points.
Also, while liquidity in the corporate bond market has been episodic, it has shown some signs of improvement recently. Meanwhile, liquidity in Treasury, MBS, and asset-backed securities markets has generally been good throughout the period. Finally, I should note that the level of outstanding nonfinancial commercial paper continued to decline in recent weeks and is now nearly 40 percent lower than it was a year ago. And as we approach year-end, the A1-P1/A2-P2 spreads have begun to widen just a bit, especially for thirty-day paper, but at least so far that widening has been much less pronounced than we saw a year ago.
Turning to Europe on page 3, the top panel graphs the three-month euro deposit libor fixing and three-, six-, and nine-month forward rates. Forward rates, which were trading above cash rates early in the summer, have been steadily declining as forecasts for euro-area growth have continued to be reduced. Forward rate agreements are now trading below cash rates, and the market widely expects a reduction in the ECB’s official target rate before year-end, perhaps as early as tomorrow. With Europe’s slowdown, euro-area corporate spreads have also widened, although perhaps not by as much as parts of our own bond market. In Europe the widening has been most pronounced at lower quality levels, such as the BBB, shown in the green line of the middle panel. Meanwhile, issuance—shown in the bottom panel—has been falling as in the United States, but the full credit picture in Europe is more difficult to gauge given the greater reliance on bank financing by European companies.
Moving to Japan on page 4, the market there has been on a bit of a roller coaster ride recently, reacting to every little report about the likelihood, timing, size, and speed of the government’s plan to clean up the banking system. At the time of your last meeting, the Bank of Japan (BOJ) had just announced its intention to buy equities from Japanese commercial banks. At first, Japanese government bond (JGB) yields spiked higher to about 1.3 percent, but they quickly retraced that rise as the market began to doubt the economic significance of the BOJ’s announcement. Then the cabinet reshuffle and the nomination of a new economic and regulatory czar raised the possibility that stronger action might be forthcoming to cleanse the nonperforming loan problem. While that might have been viewed as a negative for JGBs, given the prospect of large government expenditures, in the short run the effect has been to firm up sentiment that keeping money in the banking system is risky. So JGBs again have become attractive as a safe haven. The government’s plan, when finally announced, was viewed as rather general and a bit less than was hoped for or expected. With reform on a slower track again, JGBs continued to decline below 1 percent. The last time that JGB yields were below 1 percent was in November 1998. The other development was the BOJ’s own announcement on October 30 that it would increase the pace of its JGB purchases and its current account balances target. But that was shrugged off, as much as anything, by the marketplace. Meanwhile, bank stocks fell with the cabinet reshuffle, suggesting that investors in these stocks at least were taking the probability of reform more seriously. The biggest fall in stock prices—the bottom panel—was for stocks of the three large banks thought to be at risk of a government takeover.
Finally, let me say a word on reserves. The chart on page 5 depicts, for each maintenance period, average values for the three basic components of our total holdings of domestic financial assets—that is, for the permanent System Open Market Account, long-term repurchase agreements, and our short-term operations. This chart shows actual or projected values for the one-year period from February 2002 through February 2003, starting and ending at the seasonal trough for currency. Through July 2002, currency growth continued to contribute to a steady expansion of our total domestic financial holdings, achieved almost entirely with growth in our permanent SOMA holdings. From July to October, the total size of the portfolio generally has been flat, and it even shrank a bit recently. This shrinkage reflected essentially flat currency growth combined with movement in some autonomous factors that added to reserve balances, most noticeably the foreign repo pool. To maintain the total domestic portfolio at the appropriate level, long-term repos were compressed, falling from $18 billion in June to just about $6 billion in late October. Having the long- term repo book allowed us to compress our balance sheet quickly without selling assets from SOMA or engaging in longer-term draining operations.
In upcoming maintenance periods we face seasonal currency growth, and we expect a resumption of seasonally adjusted currency growth to more normal levels. The resulting reserve needs will be met primarily with a buildup of long-term repos. Some resumption of outright SOMA purchases is also planned, but we will proceed with that very slowly for the time being. By the end of the seasonal currency swing, long-term repos will have been built back up to about $16 billion, a level at which we plan to hold them steady for a while.
Mr. Chairman, there were no foreign operations in this period. I will need a vote
to approve our domestic operations.