Thank you, Mr. Chairman. I’ll be referring to the chart package that I hope you have in front of you. Market function has improved somewhat since the December FOMC meeting. This can be seen most notably in the term funding, foreign-exchange swap, and asset-backed commercial paper markets. In addition, some of the risks of contagion—for example, from troubled SIVs and from financial guarantors to money market mutual funds or the municipal securities market—appear to have lessened slightly. However, while market function has improved and contagion risks have diminished somewhat, the underlying strains on financial markets remain severe and may even have intensified. This can be seen in a number of areas, including (1) the wide spread of jumbo mortgage rates relative to conforming mortgages, (2) the equity prices and credit default swap spreads of a broad range of financial institutions, (3) developments in the commercial mortgage- backed securities market, and (4) corporate credit spreads and credit default swap spreads. Put simply, market participants believe that the macroeconomic outlook has deteriorated significantly and financial asset price movements broadly reflect that shift in expectations.
Turning first to the better news, term funding pressures have moderated considerably over the past few weeks. As can be seen on the first page of the handout in exhibits 1, 2, and 3, term funding spreads have fallen sharply for dollar, euro and sterling rates. For example, the one-month LIBOR–OIS spread is now 31 basis points, down from a peak of more than 100 basis points in December. However, the narrowing in three-month term spreads has been much more modest, and neither spread is back to where it was in late October or early November. Much of the recent improvement is undoubtedly due to the passage of year-end. But coordinated central bank term funding actions, including the term auction facility (TAF) and the dollar term funding auctions conducted by the ECB and the SNB, appear also to have been helpful. The first two TAF auctions went well, with bid-to-cover ratios of around 3 to 1 and stop-out rates below the 4.75 percent primary credit rate. Interestingly, term funding spreads narrowed notably on the two days when these auctions settled. This supports the notion that the TAF auctions did contribute to a lessening of term funding pressures. Moreover, market participants have generally reacted favorably to the news that the TAF auctions would continue and that the size of the January auctions would increase to $30 billion per auction. As hoped and anticipated, stigma appears to have been less of a factor for the TAF compared with the primary credit facility. The stop-out rate rose slightly in the second auction relative to the first, and some less healthy institutions bid more aggressively in the second auction. This suggests that, as depository institutions gain experience with the TAF, that might lead to an even further diminution of stigma.
As term funding markets have improved, the foreign exchange swap market has also improved in terms of function. Bid-asked spreads have narrowed, and transaction sizes have increased. The all-in cost of funding via foreign exchange swaps has fallen back down to approximate the cost of straight dollar LIBOR financing. Improvement in market tone is also visible in the interest rate swap market. As can be seen in exhibit 4, swap spreads have fallen notably from the peaks reached in the fourth quarter. Another positive development has been the improvement in the asset-backed commercial paper market. The volume of ABCP outstanding has stabilized, and the spread between the thirty-day ABCP rate and the one-month OIS rate has narrowed sharply. The spread relative to one-month LIBOR is about back to what it was before the financial market turbulence began in August (exhibit 5). Bank sponsors have generally stepped forward to take problem SIV assets back on their balance sheets, and this has reduced the risk of asset fire sales. Also, the roll-up of SIV assets onto bank balance sheets has reduced the risk of further contagion to the money market mutual fund industry. Finally on the positive side of the ledger, although the financial guarantors remain under significant stress (as shown in exhibits 6 and 7, there has been no recovery in the share prices or CDS spreads for the two major financial guarantors—MBIA and Ambac), this has had only a modest effect on the municipal securities market. Apparently, investors have decided that the quality of the underlying municipal securities is quite good—the historical default experience after all has been very low—and therefore have not been that troubled by the decline in the quality of the insurance on these instruments. That said, any actual downgrade of the financial guarantors’ credit ratings could still disturb the municipal market, in part, through its potential impact on insured municipal bond funds, which use the AAA ratings obtained from the insurance as a selling point to retail investors.
Despite these positive developments in terms of market function, financial conditions have tightened as balance sheet pressures on commercial and investment banks remain intense and as the macroeconomic outlook has deteriorated. This can be seen in a number of respects. First, large writedowns and larger loan-loss provisions are cutting into bank and thrift capital and pushing down equity prices. For commercial and investment banks, the willingness of sovereign wealth funds and other investors to replenish capital has kept bank CDS spreads from widening back to the peaks reached a few months earlier. In contrast, major thrift institutions face greater difficulties in attracting new capital because their core business has soured. As a result, their CDS spreads have soared. The spread between fixed-rate jumbo mortgages and fixed-rate conforming mortgages has climbed again (see exhibit 8). This reflects the impairment of the mortgage securitization market and the lack of spare balance sheet capacity for commercial banks and thrift institutions.
Second, corporate credit spreads and credit default indexes have widened sharply in the past few months, with a significant rise registered since year-end. As shown in exhibit 9, for investment-grade debt, the widening in spreads has roughly offset the fall in Treasury yields. As a result, investment-grade corporate bond yields have been relatively steady. In contrast, for non-investment-grade corporate debt, the widening in credit spreads has dwarfed the decline in Treasury yields. As a result, non- investment-grade corporate debt yields have climbed sharply. Although actual corporate default rates have remained unusually low, forecasts of prospective default rates have become much more pessimistic. For example, Moody’s announced yesterday that it had raised its speculative corporate debt default estimate for 2008 to 5.3 percent from 4.7 percent earlier. Exhibit 10 illustrates that, since mid-October, credit default swap spreads have been rising in both the United States and Europe.
Third, equity markets are under pressure. For example, as illustrated in exhibit 11, the S&P 500 index declined in the fourth quarter and, up through yesterday, has fallen about 5 percent so far this year. Moreover, the equity market weakness has broadened out beyond the financial sector. For example, as of yesterday’s close, the Nasdaq index, which has little weight in financials, had fallen 8 percent this year. Global stock market indexes have also generally weakened.
Interestingly, the dollar has been relatively unaffected by the deterioration in the macroeconomic outlook. After rallying into year-end, the dollar has given back much of these gains over the past week. But over the past few months, the dollar has mainly been range-bound as opposed to being in the downward channel that applied for much of 2007 (exhibit 12 illustrates what the dollar has done lately against the yen and the euro).
As the economic outlook has deteriorated, market participants’ expectations of monetary policy easing have increased markedly. As shown in exhibit 13, the federal funds rate futures market now anticipates about 100 basis points of additional easing by midyear. As shown in exhibit 14, the Eurodollar futures market anticipates a bit more than 125 basis points of further easing by year-end 2008. Currently, as shown in exhibit 15, options prices on federal funds futures imply a probability of about 50 percent of a 50 basis point move through the January 29-30 FOMC meeting. Interestingly, market expectations for an intermeeting move appear to be relatively low. Although it is difficult to be precise about this, my best guesstimate is that the market has priced in about a 1-in-4 chance of a 25 basis point intermeeting rate cut. Although that means that a rate cut today would be a big surprise to market participants, it probably would be well understood in hindsight. The sharp downward skew in rate cut expectations that has been evident in recent months persists. As shown in exhibit 16, which looks at the expected distribution of Eurodollar futures rates 300 days ahead, the mode is 3.25 percent, well above the mean of the distribution. This likely reflects market participants’ collective judgment that there are two distinct scenarios. The first (and more likely) scenario is one of an economic slowdown and a modest rise in the unemployment rate. This scenario is associated with perhaps 100 basis points of additional easing. The second scenario is a much darker one of a full-fledged recession. In this scenario, the unemployment rate would move up more sharply, and the magnitude of cumulative rate reductions would be much larger.
Finally, despite the rise in headline consumer price inflation, the uptick in core consumer price inflation, and the atmospherics created by firmer gold and oil prices, market-based measures of inflation expectations remain very well behaved. As shown in exhibit 17, both the Barclays market-based measure of five-year, five-year- forward breakeven inflation and the Board’s measure have narrowed since early November. Thank you. Of course, I’m happy to take any questions now or after David’s presentation.