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

Thank you, Mr. Chairman. I’ll be referring to the charts that were distributed a short time ago. Since the last Committee meeting, markets have been characterized by a mixture of uncertainty about—among other things—the outlook for the economy, residual geopolitical risks, and SARS. Simultaneously, the degree of risk aversion decreased and spreads narrowed, volatilities declined or stayed at low levels, equities rallied in most markets, and a consistent theme among investors was the search for yield.

The top panel on the first page graphs the U.S. dollar three-month Libor deposit rate in black and the three-month deposit rate three, six, and nine months forward in the dashed red lines. Since your last meeting, forward rates have traded in fairly narrow ranges, as markets were pushed and pulled with conflicting news—the mostly weak economic data and a corporate earnings season that, while unspectacular, did not come close to many of the most dire expectations in the markets. Forward curves and futures prices are still pricing in another ease in policy at some point, though those same curves suggest that a tightening cycle will follow shortly thereafter. Of course, this pattern of expecting lower rates to be followed by higher rates some months later has persisted for quite some time now.

As shown in the middle two panels, two- and ten-year Treasury yields also have moved in a fairly narrow range. One factor that did not seem to affect prices and yields was last week’s record refunding announcement. The Treasury will auction $58 billion of three-, five-, and ten-year notes in the next few days, with almost all of that bringing in new cash. Further, all forecasts of future deficits continue to rise. While analysts have commented about the risks that the increased supply poses, those worries have not yet shown through to yields, though perhaps they will in time as the competition for funds increases. Two possible reasons for the lack of reaction were cited: First, worries about future supply are already reflected at the long end of the curve and hence partly explain the steepness of the curve; and second the decrease in recent quarters in private-sector issuance is allowing the Treasury to borrow what it needs without bidding up rates.

The bottom panel graphs the investment-grade spread, which has continued to fall. If one excludes some very large issuers such as auto companies that have special stories surrounding them, the remainder of the index is trading near spring 1998 levels. Swap spreads, in fact, are already back to those levels. Part of this narrowing probably is a correction from what are now viewed to have been extreme levels in the autumn of 2002, when corporate governance scares were peaking. Part of the narrowing is simply due to supply and demand. Inflows continue to come into bond funds and need to be invested.

On the supply side, although issuance did tick up in late January and February, it fell again as the war approached, and it has stayed low since then. Dealers note that corporations are using free cash flow and what little corporate issuance there has been to repay debt and de-lever their balance sheets. This helps to explain the credit quality improvement, though it also implies that less is going into investment than would normally be the case.

Meanwhile on the demand side, investors have pushed out the maturity and credit risk curves in the search for higher yields. The bottom right panel graphs the narrowing of high-yield and emerging-market spreads. Funds specializing in both asset classes have had inflows, and with only a limited supply coming to the market, the competition has been intense and spreads have narrowed sharply. Just to take one example, Brazil issued a $1 billion five-year global bond that was six times oversubscribed. A week ago the bond was issued to yield 10.7 percent, and it has rallied in the week since then. It now yields 9.8 percent. The issue also included a collective action clause, which did not appear to affect demand. The Brazilian real, Mexican peso, and South African rand were among the currencies that benefited from investors’ search for higher yielding currencies and asset markets.

Consistent with the narrowing of spreads and less risk aversion in recent weeks, implied volatilities have decreased or stayed at relatively low levels. Page 2 graphs long-term implied volatilities on the S&P 100, the two main exchange rate pairs, and the ten-year Treasury futures since January 2000. The better performance of U.S. equity markets in recent weeks—the S&P 500, for example, is up 15 percent—has coincided with the fall in implied vols. As shown in the top panel, which depicts the S&P 100 volatility index, that measure of equity volatility is back to below the 25 percent level for the first time since corporate governance worries heightened after the WorldCom collapse. Currency volatilities continued to trade in well-worn ranges, near the 10 percent level that has prevailed for some time. These volatility levels have been maintained both during the appreciation of the dollar in the beginning of the period and during the more recent period of dollar depreciation. The implied volatilities in the ten-year Treasury futures contract have continued to ebb in recent weeks to levels observed in the first half of 2001. Part of that recent falloff in volatility may also be due to the decline in the Mortgage Bankers Association’s Refinancing Index, as prepayments have slowed. That also may have lessened the demand for hedging by mortgage investors and corporate treasurers.

Turning to Europe, the top panel on page 3 graphs the Libor fixing for euro three- month deposits in black and the implied rates three, six, and nine months forward in green. The forward rates continue to trade below the cash rate and market participants expect further easing from the ECB, as forecasts for European growth are still being trimmed. In the middle panel, credit spreads in the euro area continue to narrow as well. In particular, the lower end of the investment-grade universe has outperformed the rest. But unlike the case in the United States, issuance actually picked up early this year, as shown in the chart at the bottom left, so supply there is holding up. One possibility is that European companies are now going through some of the same dynamics that U.S. companies went through in 2001 and 2002, when they issued debt heavily in order to refinance and restructure debt and to extend the term of maturing commercial paper.

In the foreign exchange markets, the euro has continued to rise past 112 and is now at the 113 level against the dollar—its strongest level since February 1999, which was roughly six weeks after the euro’s launch. Investors shifting assets into the euro area reportedly include central banks, Japanese insurance and pension companies, and European institutional investors who have preferred to keep funds at home rather than move them overseas. Although we don’t think of the euro as a high-yielding currency per se, both short- and long-term rates are meaningfully higher than those for the two G-3 counterpart currencies.

Turning to page 4, Japanese markets show no signs that the deflationary pressures in that country are abating. The banking situation continues to post challenges for Japanese policymakers, and the recent declines in Japanese stocks have accentuated those worries. The Nikkei stock index fell below 8,000 during the intermeeting period for the first time since 1983. This has again raised talk in Japanese policy circles about measures such as so-called price-keeping operations to stem the declines in equity prices and hence conserve capital resources of the banks and insurers. Unlike most other major equity markets, the Nikkei did not rally in mid-March. That divergence from other equity markets is depicted in the top panel. The S&P and DAX, to take just two examples, came off their lows rather sharply, whereas the Nikkei continued its steady decline toward and then below the 8,000 level. Today it is just above that level. The Japanese bond markets also have been gloomy, as shown in the middle panel. The ten-year yield is trading at about 61 or 62 basis points, and the yield on the twenty-year bond is at 94 basis points. Among benchmark issues, only the thirty-year yield, trading at 1.06 percent, has a positive integer before the decimal point, though not by very much.

The BOJ’s policy stance has pushed investors out on the yield curve and to some degree into private-sector and foreign assets. The right middle panel shows the recent narrowing of private-sector spreads in Japan, which is not unlike the patterns observed in dollar and euro area fixed income markets. But let me note three points of caution. First, as we know, companies in Japan rely more on bank financing; bond market issuance is low compared with both their U.S. and European counterparts. Second, the data are poor. But net new issuance is probably flat or perhaps even negative in the lower-rated segments, which would help to explain some of the spread compression. Third, spreads widened substantially in late 2001 when some fund managers were faced with large losses, and the ensuing liquidation widened spreads—especially for lower-rated paper. Those spreads are only now reverting to the levels we saw in the summer of 2001.

The noisy chart at the bottom left graphs the TOPIX bank sub-index and the share prices of the four major Japanese banks, all of which are down substantially as the prospect for improvement in their business recedes. Mizuho, for example, reported a $19 billion loss a week ago. Ironically, the spreads on Japanese bank debt have nevertheless narrowed during 2003. The bottom right panel graphs the spread for each of the four major banks between their five-year senior debt and the five-year JGB yield. I would make two points. First, all the spreads have narrowed and are converging, suggesting little in the way of differentiation among the banks—or at least less than had been the case some months ago. Second, these spreads obviously represent very low absolute yields. With the five-year JGB yield itself at 21 basis points today, a spread of 10 basis points on Sumitomo’s debt, for example, means that the bank is able to sell five-year debt at 31 basis points.

Moving to the next page, one of the stars in the currency market has been the Canadian dollar. In recent trading sessions the Canadian dollar has risen above 70 cents and is now trading at its strongest level since 1997. Among the reasons for the Canadian dollar’s performance are Canada’s strong economic performance, higher yields, less overcapacity in Canadian industry, a large energy sector at a time when prices have generally been high, and the Bank of Canada’s move to tighten monetary policy. Canadian ten-year yields are about 1 percentage point higher than those on comparable U.S. instruments; and at the short end, Canadian interest rates are about 2 percentage points higher. The divergence in policy has also had a different effect on the yield curve. The middle panel graphs the two-to-ten-year U.S. Treasury curve in blue and the comparable data for Canada in red. While the U.S. curve has been steep at between 220 to 240 basis points all year, the Canadian curve has actually flattened by about 60 basis points and is currently only half as steep as the U.S. curve. The World Health Organization’s decision to issue a travel advisory for Toronto had periodic but only transient effects on Canadian markets.

The Hong Kong and Chinese markets, on the other hand, had at times a more pronounced reaction to SARS-related news but perhaps less than one might have expected given the sheer volume of coverage the story received. At the bottom left in blue is a graph of the Hong Kong dollar, which is fixed at 7.8 to the dollar. The one- year forward rate moved upward in mid- to late April to 7.83 but since then has eased back somewhat. At the bottom right, China’s spot exchange rate is depicted in blue and the implied one-year renminbi nondeliverable forward rate in red. The discount on the renminbi has narrowed somewhat, but all in all the reaction was fairly modest. Equities in both Hong Kong and China, however, did fall, although again perhaps not as dramatically as one might have expected.

Mr. Chairman, there were no foreign operations in the intermeeting period. I will need a vote on domestic operations. And I’d be happy to answer any questions.

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