Transcripts of the monetary policymaking body of the Federal Reserve from 2002–2008.

Thank you, Mr. Chairman. I’ll be referring to the handout with the blue on the front. The market turbulence that began in earnest on February 27 is now a distant memory. Risk appetites have recovered, volatility in the fixed income and equity markets has declined, and the U.S. equity market has climbed to a new high. Exhibits 1, 2, and 3 show the correlation matrices for the daily price and yield movements in the fixed income, equity, and currency markets. The blue-shaded boxes indicate correlations with an absolute value greater than 0.5. As shown in exhibit 1, until February 27, the correlations across most of these asset pairs were low. However, beginning on February 27 through mid to late March, correlations rose sharply as risk-reduction efforts dominated financial markets. This shift can be seen in exhibit 2, where all but one of the boxes are shaded blue. Since the March FOMC meeting, calm has returned, with asset-price movements again becoming mostly uncorrelated. The matrix shown in exhibit 3, which shows the correlations since the March FOMC meeting, looks similar to exhibit 1.

As I mentioned in my briefing at the March meeting, although the turmoil in the markets was related mostly to risk-reduction efforts, in certain areas—the subprime mortgage market is the best example—the deterioration in performance was related mostly to fundamental developments. As can be seen in exhibits 4 and 5, which plot delinquencies and losses for the notorious 2006 subprime vintage, the deterioration in performance has continued apace. Exhibit 4 shows that delinquencies of more than sixty days for the 2006 vintage are even higher than those for the 2001 vintage. This is noteworthy because in 2001 the U.S. economy experienced a mild recession and payroll employment was declining. Even more noteworthy is the trend of losses for the 2006 vintage. As shown in exhibit 5, losses for the 2006 vintage are running at about triple the rate of the 2001 vintage. This poor loss experience appears due both to deterioration in underwriting standards and to less-favorable underlying conditions—for example, the softening trend of home prices in many local markets.

The fundamental deterioration in the subprime mortgage sector can also be seen in other measures of performance. For example, exhibit 6 illustrates the behavior of BBB-rated spreads for the ABX, CDS, and cash markets. The ABX represents an index of twenty credit default swaps on twenty BBB-rated asset-backed securities, and the BBB cash index represents the yield spread on the BBB-rated tranches of the asset-backed securities. Thus, the ABX index references, via the credit default swap market, the underlying asset-backed securities market. As can be seen in this exhibit, although all three spreads have recovered somewhat over the past few weeks, spreads remain much wider than earlier in the year. Also, note that ABX spreads remain considerably wider than the CDS and cash spreads that they reference. This situation underscores the illiquidity of the ABX market and may partially reflect the lack of a natural constituency of investors who might wish to take the long side of this index, especially when the subprime market is under stress. The problems in subprime mortgages have spilled over into the collateralized debt obligation (CDO) market. As you may recall, many CDOs have a substantial proportion of their assets in lower- rated subprime asset-backed security tranches. After widening sharply in late February, the yield spreads on mezzanine structured-finance CDOs have shown no recovery. In fact, as shown in exhibit 7, the spreads on these CDOs have continued to widen.

At the last FOMC meeting, I argued that the selloff in the equity market that began in late February had at least one fundamental component—the reduction in earnings expectations for 2007. Yet the equity market has recovered quite strongly. I think that this can be explained by three factors. First, earnings in the first quarter were stronger than expected. The Board staff estimates that first-quarter earnings for the S&P 500 will have increased about 9 percent on a year-over-year basis. Second, perhaps as a result, earnings expectations have stabilized. As shown in exhibit 8, the median bottom-up equity analyst forecast for S&P 500 earnings growth in 2007 has stopped falling and remains above 6 percent. Third, buyout and buyback activity continues unabated. Exhibit 9 shows the flow of funds data on net equity issuance. As can be seen, the outstanding supply of U.S. equities is shrinking rapidly, in contrast to the increase in net supply that occurred over the 2000-04 period. Buyouts and buybacks may also be a factor explaining the recent behavior of corporate credit spreads. As shown in exhibit 10, high-yield and emerging-market debt spreads have mostly recovered since the late February widening. However, investment-grade debt spreads remain wider than in early 2007. Investment-grade debt performance may be lagging because investors fear that the credit quality of this debt will be undermined as buyouts and buybacks result in increased leverage.

Turning now to the currency markets, an emerging story is the weakness of the U.S. dollar. As shown in exhibit 11, the dollar has fallen about 3 percent against the euro since the start of the year and is virtually flat against the yen over this period. The weakness against the euro appears to reflect mostly changing interest rate expectations. Exhibit 12 plots the spread between the June 2008 Eurodollar contract and the euribor contract. As can be seen in this exhibit, the expected interest rate differential has fallen about 40 basis points this year. As this has occurred, the euro has strengthened. To date, the dollar’s weakness has not been of much concern to market participants. The decline has been gradual, and investors perceive that global imbalances are unwinding smoothly. Nevertheless, the subprime debacle points to another source of risk for the dollar. In recent years, the net acquisition of dollar- denominated financial assets by foreign investors has shifted to private flows from public flows and to corporate bonds, including asset-backed securities and CDO obligations, from Treasury and agency debt. This shift is shown in exhibit 13. My worry here is that the problems in the subprime and alt-A mortgage market could ultimately affect foreign investors’ appetites for U.S. asset-backed securities and CDOs. For example, a particularly poor performance of lower-rated ABS and CDO tranches, coupled with the widespread corporate rating downgrades that might be associated with such poor performance, could cause foreign investors to lose confidence in investing in dollar-denominated debt.

In terms of U.S. interest rate expectations, investors expect no near-term change in policy. However, market participants continue to expect significant easing late this year and in 2008. Interest rate expectations for the remainder of 2007 are back where they were at the time of the January FOMC meeting. Looking at the federal funds rate futures market in exhibit 14, we can see that only about one 25 basis point rate cut is expected in 2007. In contrast, expectations for 2008 more closely resemble expectations at the time of the December and March FOMC meetings, not the January meeting. As can be seen in exhibit 15, which plots Eurodollar futures contract yields, investors expect substantial monetary policy easing in 2008. Why this delayed pattern of easing? There are three potential explanations. First, as I have noted before, futures market yields reflect the mean, not the modal, forecast. To the extent that investors perceive a moderate risk of significant economic weakness that could lead to pronounced monetary policy easing, then the yields in the futures market could be well below the modal forecasts of investors. Second, some investors may disagree with the FOMC about the outlook. In this case, they might anticipate that it will take time for the FOMC to come around to their way of thinking—leading to rate cuts that occur only later. Third, some investors may anticipate that inflation will moderate. As this happens, the FOMC might gradually reduce its nominal federal funds rate target following lower inflation—essentially keeping the real federal funds rate constant.

Finally, the survey of the primary dealers shows little change in interest rate expectations since the last FOMC meeting. Exhibits 16 and 17 compare dealer expectations with market expectations before the March FOMC meeting and before this meeting. The horizontal bold lines represent market expectations. The blue circles represent the different dealer forecasts, and the size of a circle represents how many dealers have that forecast. The green circles represent the average dealer forecast for each period. The average of the primary dealer forecasts is consistent with only slightly more than 25 basis points of easing through the end of this year— not much different from what is priced into the federal funds futures market. As can be seen, the dispersion of the dealer forecasts over the next few quarters has narrowed a bit. However, considerable disagreement remains about whether short-term rates will be higher or lower a year ahead. Also, the average of the dealer forecasts for 2008 remains considerably above market expectations. This presumably reflects mainly the “downside risks” notion, which should cause the modal forecasts of dealers to be higher than the mean expectations represented by futures prices. I’ll be happy to take any questions.

I will need approval for domestic operations; there were no foreign operations. Also, I circulated a memo asking you to vote to approve renewal of the swap lines to Canada and Mexico.

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