Thank you very much, Mr. Chairman. Thank you for those words. The most striking aspect of the intermeeting period was the conviction that markets developed about a benign 2007 outlook both for the economy and for monetary policy. Until Friday’s employment report, most of the incoming data were viewed as being weaker than expected. This encouraged market participants to price in lower policy rates for the first half of 2007.
If you would turn to the handout, the top panel on page 1 graphs the Eurodollar futures strip out to 2010 as of the last FOMC meeting, in blue, and as of last Friday, in red. Near-term contracts declined less than 20 basis points, whereas longer-term contracts fell more than 30 basis points. Until Friday’s employment report, future short-term rates were even lower, as the markets had come to expect that the weaker housing, auto, and manufacturing data would persist and lead to a first-quarter easing of policy by the Committee. Interestingly, the markets shrugged off the Chairman’s speech on November 28 and other comments by Committee members that focused more on inflation risks. Indeed, in this period the markets were focused more on data—especially data that seemed to validate a view that the economy was slowing— than on speeches.
Longer-term yields also declined. The middle panel graphs the target fed funds rate, the green line, and two-year and ten-year Treasury yields since January 2006. Both two-year and ten-year Treasury yields tracked the upward path of the target fed funds rate but began to fall almost to the day that the target peaked. Ten-year yields have fallen another ¼ percent since the last meeting and are now about 75 basis points below the target fed funds rate. This is the largest inversion of this spread since February 2001, when that easing cycle began. As shown in the bottom panel, breakeven inflation rates are little changed and, if anything, have tended to rise at shorter tenures. Most of the decline in nominal rates was mirrored by a fall in real rates as market participants factored in lower activity in the period ahead.
Despite reminders in Committee members’ speeches about upside inflation risks, market participants increasingly focused on the probability that policy would be eased in the months ahead. This can be seen in the top panel on page 2, which graphs the calendar spread between the March 2008 and the March 2007 Eurodollar futures contracts. Back in May these two contracts were on top of each other, but then they gradually inverted, implying that rates were expected to be lower in March 2008 than in March 2007. Market participants anecdotally refer to past episodes when the Committee has eased policy several months after its last tightening as weakness in output began to show through. Two episodes are frequently cited: late 2000 and early 1995. The middle panel graphs the calendar spread between the March 2002 and March 2001 contracts. That relationship began to invert about five months after the last tightening, in May 2000. The negative inversion peaked at about 50 basis points in late 2000, and the Committee eased policy in early 2001—the first of a long series of cuts. The mid-1990s episode is somewhat different in that the yield curve and Eurodollar calendar spreads flattened but never convincingly inverted, as shown in the bottom panel. Five months after the last tightening in February 1995 came an ease in July. In short, at least as measured by futures spreads, the expectation for an upcoming ease appears to be even stronger than in the previous two episodes.
Equity markets have been undaunted by the signs of weakness that the bond market is responding to. As shown in the two top panels on page 3, the major equity indexes have had strong rallies since midyear. The prospect of lower interest rates has trumped the possible slowdown in earnings growth that might emanate from a weaker economy. Indeed even a weaker dollar has not dented confidence of either equity or fixed-income investors. If anything, a gradually falling dollar is seen as a positive for large internationally oriented stocks such as those in the Dow or S&P indexes.
After being confined to a narrow range, the dollar depreciated rapidly against most major currencies in late November and early December. As shown in the middle left panel, the euro rose above $1.32 while sterling looked poised to threaten the $2 level before consolidating near $1.96. Sterling is at its highest value versus the dollar in more than fourteen years. The dollar’s movements against the yen have been more range-bound as capital flows out of Japan have limited the yen’s appreciation. The recent lurch in the dollar reflects improved sentiment toward European economies. It also followed some comments by a Chinese official around Thanksgiving that were interpreted as conveying worries about continued accumulation of dollars among Asian central banks. Reports of diversification by other central banks have fed this rumor mill. Yesterday a prominent former member of this Committee weighed in by suggesting that the dollar had further to go on the downside and that central banks should not concentrate their reserves in one currency. Surveys of investors and speculative traders suggest that short dollar positions are at something of an extreme by historical standards. Such negative sentiment is also borne out by risk reversals, as shown in the bottom right, which show that dollar puts are consistently bid relative to dollar calls and have become more so recently. Of course, once sentiment gets extreme, the market becomes susceptible to sharp setbacks. Indeed, exactly two years ago, the euro appreciated dramatically into year- end peaking at $1.36, only to have all those gains fully reversed in the early months of 2005.
As shown on page 4, volatilities continue to trade at very low levels. The top panel graphs the one-month implied volatility for the two major dollar currency pairs. Since April/May, volatilities have fallen to new lows. Similarly, in the middle panel, the VIX (Chicago Board Options Exchange Volatility Index) has fallen back to levels last seen a decade ago. In the Treasury markets, implied volatility is at or below levels seen in the summer of 1998. With volatilities low and expectations of a benign environment persisting, dealers continue to report interest in carry trades and sales of structured products with embedded options.
One symptom of the benign financial environment that analysts point to is the higher level of mergers and acquisitions activity in general and leveraged buyouts in particular. The top panel on page 5 graphs the rise of LBOs since their nadir in 1992. The middle panel deconstructs the high-yield bond market according to how the proceeds were used. The red bar—representing proceeds being used to finance M&A and LBOs—has been rising in the past three years. Also rising has been the value of bonds rated CCC or less at the time of issuance. In short, the market has been more than willing to finance lower-rated paper for purposes other than traditional investment in plant and equipment. It is fair to say that risks are rising.
But the development graphed in the bottom panel is in some ways more interesting. This is the rise of the so-called leveraged-loan market, which exceeds amounts raised in the high-yield bond market, represented by the yellow line. As shown by the blue bars, the portion of such loans originated by or syndicated to nonbank investors such as pension funds or hedge funds has risen and now exceeds the amount taken down by the banks. Private equity sponsors are increasingly turning to this source of funding to finance acquisitions.
Meanwhile private equity deals are also evolving. The size has obviously grown, but two other aspects are worth noting. First, many deals no longer involve acquisitions of underperforming companies. In many cases the acquired companies are performing reasonably well but are viewed as being able to operate with higher levels of debt. It’s not clear what value added the private equity buyer is providing in such cases. Second, LBOs are no longer being done solely in industries with predictable cash flows. Several deals were recently announced in volatile businesses such as semiconductors. The poster child for such deals is Freescale Semiconductor. The company was just acquired for $17.6 billion. Cash flow barely covers interest payments, and the margin for error is very small for a company in a notoriously volatile industry. Cynics argue that tomorrow’s nonperforming loans are being originated as we speak.
Mr. Chairman, I am happy to say, once again, that there were no foreign operations in the period. I will need a vote to approve domestic operations.