Speech

Whither the U.S. Credit Markets? ConstructionFinancialManagersAssociation Co-sponsoredbytheAssociatedBuildersandContractorsandtheBuildersExchange Louisville,Kentucky October26,1998 Iam delighted to be here this evening to overtheten-yearTreasuryyield.Thedailyaverage meet with the Construction Financial ofthatspreadwasabout185basispointssofar Managers Association at this meeting co- inOctober,comparedwithanaverageoverthe sponsored by the Associated Builders and entireperiodsince1959of68basispoints.The Contractors and the Builders Exchange. I had figurealsorevealsthatthespreadintoday’smar- originally planned to provide an overview of the ketisindeedhigherthanwehaveseensince1959. state of the economy but decided instead to con- ThelighterlineinFigure1showsthespread centrate on the very unusual situation in today’s oflower-ratedcorporatesecurities—thosecarrying creditmarkets.Ithinkthisdecisionisfullyappro- aBaarating—overthe10-yearTreasuryyield.So priate given that interest rates and credit avail- farinOctoberthatspreadhasaveraged265basis ability are critical issues for all parts of the con- points.Aswecanseefromthefigure,thisspread struction industry. ishigherthannormal—theaverageovertheentire TheU.S.financiallandscapechangeddramati- periodis167basispoints.However,aspreadthis callyinmid-Augustofthisyear.Initially,whatwe largeisnotallthatuncommonsince1959. sawwasadramaticwideningofqualityspreads Weshouldalsocomparethecurrentspreads aslower-ratedcorporatebondsfellinyieldrelative totheirrecentlevelsbeforeAugust.Overthepast toTreasurybonds.Intheensuingweekswefound severalyears,theAaaspreadhasbeeninthe thatthenumberofnewbondscomingtomarket neighborhoodof100basispointsandtheBaa felldramaticallyfromthepaceearlierintheyear. spreadhasbeenintheneighborhoodof150basis Inaddition,thestockmarketbecamemuchmore points.So,clearlythespreadshaveincreased volatileandonaverageequitypricesdeclined.As sharplysinceAugustandthatisthephenomenon inthebondmarket,thenumberofnewissuescom- weneedtounderstandandthatmonetarypolicy ingintotheequitymarketdeclinedsubstantially. makersneedtoconfront.Atthispoint,Iwantto WhatIwanttodothiseveningistodiscuss putasidepolicydiscussion;wemustlookmuch insomedetailwhathashappenedinthecredit morecarefullyatunderstandingthesituation marketsandtoworkonprovidingadeeperunder- beforewediscussthepolicyresponse. standingoftheseeventsandoftheirpossible Theverticalshadedareasinthefigureshow implicationsfortheU.S.economy. periodsofrecessionasdefinedbytheNational BureauofEconomicResearch.Inalmostallcases historically,spreadswidenedonlyafterarecession THE FINANCIAL MARKETS SINCE wasclearlyunderway.Suchbehaviormakesper- AUGUST fectlygoodsenseasperiodsofrecessionbring Letmebeginthisdiscussionbyreferringto decliningcorporateearningsandlessearnings Figure1reportingcorporatebondspreadsmonthly coverageofcorporatedebtservice.Theeffectis from1959todate.Theboldlineinthefigure moreimportant,ofcourse,forlower-ratedbonds showsthespreadoftheAaaaveragebondyield suchastheBaabonds.Withincreasedriskof 1 FINANCIALMARKETS Figure 1 Corporate Bond Spreads default,investorsdemandhigheryields.More- spreadthathasopenedupisquantitativelymore over,ingeneralwecanobservethattheincrease aconsequenceofthesteepdeclineintheTreasury inthespreadisgreaterthedeepertherecession. yieldthanaconsequenceofanincreaseinthe Therecessionsof1973-75and1981-82weremore AaaorBaayields.Ifwelookatthelower-rated seriousthantheotherrecessionsshowninthe bondsthemarketreferstoas“junk”bonds,the figure,andthepeakspreadswerehigher.Ifwe storyisbroadlythesameexceptthatthejunk- gobackfurtherinU.S.history,wewouldobserve bondyieldshavegoneupinabsolutevalueso exactlythesamething. thatthespreadhasbecomequitelarge.Basedon Manyobservershavecommentedonfigures theMerrillLynchhigh-yieldbondseries,this similartoFigure1,althoughtomytastetheytoo spreadaveraged566basispointsinSeptember oftenconcentrateononlythelastfewyearswith comparedwithmorerecentexperiencein1997 theconsequencethatthelessonsfromhistory and1998untilAugustofaspreadcloserto300 aremissed. basispoints. Inowwanttoturntoadifferentwayoflook- Wecantellabroadlysimilarstoryatthe ingatthissamesubjectbyexaminingtheabsolute short-endofthemarket.Thespreadbetweenthe levelsoftheyields.Figure2providestheinforma- yieldsonbankCDsrelativetothethree-month tionweneed.Theboldlineinthefigureshows Treasurybillratehasopeneduptothetuneof the10-yearTreasurybondyield.Aswecansee, 142basispointsfortheweekendingOctober16 thatyieldhasdroppeddramaticallyinrecent comparedwithanaveragespreadovertheperiod months.TheAaaandBaayieldshavealsofallen since1964of81basispoints.Thisyearbefore somewhat,althoughnotasmuch.Therefore,the Augustthespreadwascloserto60basispoints. 2 WhithertheU.S.CreditMarkets? Figure 2 Long-Term BondYields ThustheCDspreadhasincreasedbysomething Spreadsdonottelltheentirestory.Idon’thave intheorderof80basispointssinceAugust.What thevolumenumbersatmyfingertips,butitis thismeansisthatthecostofpurchasedfundsto evidentthatthenumberofnewissueshasdeclined largebankshasrisensubstantiallyrelativetothe quitesubstantially.Towhatextentvolumeis Treasurybillrate. downbecausepotentialborrowerssimplycannot Thecommercialpaperratehasalsorisenrela- placeriskierbondsduetoweakdemandforsuch tivetotheTreasurybillrate.Inmid-Octoberthat bondsandtowhatextentvolumeisdownbecause spreadwasabout127basispointscomparedwith potentialborrowersaresimplywaitingforspreads anaveragespreadsince1971of71basispoints. TheaveragespreadthisyearbeforeAugustwas tonarrowIdonotknow.Eitherway,thesharply moreintheneighborhoodof50basispoints, reducedvolumeisanothermeasureofthemag- whichmeansthatthecommercialpaperspread nitudeofthecurrentdisturbanceinthecredit hasrisenbysomethingintheorderof80basis markets. pointssinceAugust,oraboutthesameasthe Finally,becauseofthewidereportingofthe increaseintheCDspread.Thusthecostoffinanc- stockmarket,everyoneisfamiliarwiththe ingtothelargecorporationsthatutilizethecom- declinesintheequitymarketandthegreatly mercialpapermarkethasrisenby80basispoints increasedvolatilityinthatmarket.Theincreased relativetotheTreasurybillrate.Hereagain,as volatilityisindeedquitedramatic;wehaveall inthebondmarket,theabsolutecostoffinancing intheCDandcommercialpapermarketshasnot experiencedthegut-wrenchingupanddowns— goneup;thespreadshavewidenedbecausethe thedownshitdeeperinthegutthantheups—in T-billratehasgonedownsubstantially. thestockmarket. 3 FINANCIALMARKETS Oneotherthingthathashappened—little UNDERSTANDING THE CREDIT notedbythegeneralpublic,butmuchcommented MARKET DISTURBANCE uponbymarketprofessionals—isthespreadthat hasopenedupwithintheTreasurybondmarket Nowthatwehavereviewedwhathashap- betweenon-the-runandoff-the-runissues.For penedinthecreditmarkets,let’stalkabitabout example,thelongestbondoutstanding,which tryingtounderstandtheseevents.Ialreadycom- hasamaturityofalittlelessthan30years,was mentedbrieflythatinthebondmarket,asyou recentlytradingatayieldofabout35basispoints canseefromthefiguresIdistributed,thespreads lessthanthenextlongestbond.Thatspreadnar- historicallyhavebeenrelatedtorecessions.Ialso rowedsomewhatlastweek.Ordinarily,thisyield commentedthatitmakesperfectsenseforspreads differenceisintheneighborhoodoffivetoeight towidenundersuchcircumstances.Onepossible basispoints.Thesamephenomenoncanbeseen interpretationoftheincreasedspreadstodayis whencomparing10-yearand9-yearT-bonds,and thatarecessionhasalreadystarted.Thatpossi- 5-yearand6-yearT-bonds.Themarketliquidity bilityseemsremotetome,asthecurrenteconomic isfarhigherfortheon-the-runissuesat5,10,and datasimplydonotpointtoanactualdeclinein 30yearsthanfortheneighboringbonds.Forsome economicactivityalreadyinplace.Themost reason,themarketconcentratesonthoseparticular recentdatasuggestthattherateofgrowthhas maturities.Finally,bid-askedspreadsforanygiven slowedabit,butnotthattheoveralleconomyis issueintheTreasurymarkethavealsowidened. alreadyonadownwardtrack.Moreover,most Itseemsreasonabletointerprettheseyield forecastersarecallingforcontinuedexpansion spreadswithintheTreasurymarketasproviding nextyear,althoughthereareafewwhobelievea ameasureofthemarket’stremendoushungerfor recessionisontheway. liquidityandthemarket’stremendousuncertainty. Mypersonalobservationonarecessionfore- Theon-the-runissuescanbetradedinmuch castisthatifarecessiondoesstartearlynextyear, largervolumeandwithamuchlowerbid-asked thecircumstancessurroundingitwillbeunique spread—althoughahigherbid-askedspreadthan inU.S.businesscyclehistory.AsfarasIknow, normal—thantheneighboringissues,sotheseare lookingbackontheentirechronologyofreces- theissueswheremarketprofessionalsplacefunds sionsstartinginthe1850s,thereisnocasein onatemporarybasis.Itmayseemstrangethat whichtheperiodleadinguptoarecessionwas traderswoulduseathirty-yearbondasaplace characterizedbylow-to-declininginflation, toparkfundstemporarily,butthatseemstobe declininginterestrateswellinadvanceofthe thewaythemarketworks. cyclepeak,andhigh-and-risingmoneygrowth. So,tosummarize,throughoutthecreditmar- I’velearnednottosaythatsomethingisimpossible ketsweseeevidenceofaverylargechangein inthisbusiness,butwemustformourjudgments investors’attitudesstartinginmid-August.The fromourexperienceandtomeitseemsunlikely equitymarketsareonaveragedownandmuch thatarecessioniseitheralreadyunderwayorjust morevolatile.Qualityspreadshaveopenedup aroundthecorner. substantiallyinthebondmarketandinthemoney Whenwelookatthespreadsattheshortend market.Thevolumeofnewissuesinboththe ofthemarket—theCDandcommercialpaper equitymarketandthebondmarkethasdeclined spreads—wecanobservetwofeaturesofourexpe- verysubstantially.WithintheTreasurybondmar- riencesince1959.First,thespreadsarecharac- ket,off-the-runissuestradeatmuchhigherthan terizedforthemostpartbyshort,sharppeaks. usualyieldsrelativetoon-the-runissues.And Second,wecanidentifyspecificeventsthattrig- bid-askedspreadsthroughoutthebondmarket, geredthesharpincreasesinthespreads.Itisuse- includingtheTreasurybondmarket,arehigher fultorecountthesespecificeventstounderstand thannormal. betterwhatisgoingon. 4 WhithertheU.S.CreditMarkets? In1970,thePenn-CentralRailroaddeclared Therearestrawsinthewindsuggestingthatthe bankruptcy.Penn-Centralhadissuedcommercial flowsoffinancingthroughthemarketsarepicking paperwhichtheratingagencieshadratedprime. uponceagainandthatweareheadedbacktoward Holdersofprimecommercialpaperissuedby amorenormalstateofaffairs.Spreadshavenar- othercorporationswereunderstandablytaken rowedabitinrecentdays,andthestockmarket abackwhentheyheardofthePenn-Central isupsignificantlyfromitslows.But,Idowant default.Theirreactionwasperfectlynaturaland toemphasizethatmyobservationsreflectstraws understandable:theyaskedwhetherothercom- inthewind,andIwouldnotpersonallybesur- mercialpaperratedprimemightalsobesuspect. prisedifthesituationeitherlastslongerorsorts Theimmediateeffectwasasharpincreaseinthe itselfoutquickly.Putanotherway,thereisnec- commercialpaperspreadoverT-billsasinvestors essarilyawidevariancetoanyreasonablefore- insistedonahigheryieldtoprotectthemselves. castaboutthismatter. Beforeverylong,however,themarketsortedout Nowletmetrytoputtheseobservationsina theborrowersthattrulywereprimefromothers somewhatgeneralframework.Hereishowthe thatweremorequestionable.Thequestionable processworksasbestIcanunderstandit.Some borrowerswerenolongerabletoborrowatprime shockorpieceofnewshitsthemarketandtakes andtheprimeborrowersborrowedatanormal peoplebysurprise.Manyinvestorsrunforcover spreadovertheT-billrate.Thehiccupinthe untiltheycansortoutthesituation.Investors marketdisappearedquickly. moveawayfrommoreriskysecuritiesandpark Similardisturbancesthatresultedinsharply fundstemporarilyinsafe,highlyliquidTreasury increasedspreadscanbeidentified.TheFranklin securities.However,thewidespreadsthatopen NationalBankfailedin1974,ContinentalIllinois upprovidetheincentivetothemarketstosortout Banknearlyfailedin1984,andthestockmarket theproblemquickly.Afterall,ifyoucaninvest crashedin1987.Inallthesecasesweobserve inaslightlyriskysecurityataspreadovera spikesinspreadsintheCDandcommercialpaper Treasurysecuritythatmorethanamplycompen- markets.Butthekeypointisthatinachartthe satesfortherisk,thenwhynotgoforit?The spreadslooklikespikesratherthanlongplateaus marketisinthebusinessofassessingrisksand atthetimesoftheseevents.InthesecasesI’ve obtainingthehighestpossibleyieldconsistent mentioned,andothers,themarketstraightened withtheriskbeingassumed.So,whilethemarket outthematterquiteliterallyinamatterofweeks. ingeneralmaybedominatedforafewweeksby Thistime,thedisturbancehaslastedsome- highlyrisk-adverseinvestors,moreastuteand whatlongersofarthansimilardisturbancesinthe adventurousinvestorswillstarttoplacefunds past.Theshocktothemarketswasaparticular inthesecuritiesthatofferahighyieldrelativeto pieceofnews—theRussiandefaultonitsdebtin theriskinvolved.Thisprocessgraduallyspreads midAugust,ordebtreschedulingforthosewho totherestofthemarket,andnotalwayssograd- wanttobepoliteandstrictlyaccurate.Apparently, theRussiansituationledmanyinvestorstothink ually.Thatiswhythefigureonthespreadshows muchmorecarefullyaboutrisksinthemarket- spikesratherthanlongplateaus. placeandtowonderwhetherspreadswereade- Ihaven’tmentionedbanklendingasyet, quatetocoverthoserisks. becausenotmuchhashappenedonthatfront. Wereallydonotknowhowlongspreads TheinformationIhaveindicatesthatlargebanks willremainhighandthevolumeofnewissues mayhavepulledbackabit,lookingharderatthe abnormallylow;thecurrentexperienceismore riskinessofpotentialloansandshyingawayfrom generalandpervasivethantheexampleswesee sometheywouldhaveacceptedbeforeAugust. inhistory.Butmyownpersonalguessisthatthe However,mostsmall-andmedium-sizedbanks markettodayiswellintotheprocessofsorting havecontinuedtheirlendingpolicieslargely outthesolidcreditsfromthelesssolidones. unchanged. 5 FINANCIALMARKETS IMPLICATIONS OF THE CREDIT Letmefinishwithafewobservationsonthe currenteconomicsituation.Thefundamentals MARKET DISTURBANCE oftheU.S.economyreallydoseemtometobe Itisprettyobviousthatifthespreadsremain sound.Iamnottryingtosoundoptimisticinan highforanextendedperiodoftime,andifthe efforttocalmthemarket,orforanyotherpurpose. flowofnewcredittoborrowerswhowouldhave Suchastancewouldn’tworkfortheFedformore readilyqualifiedforfundsonlyashorttimeago thanafewdaysiftheflowofnewsreflectsfunda- remainslargelycutoff,thentheeconomywill mentalsthatarenotreallysound.Itistruethat almostcertainlyslowsubstantially.But,please thecreditmarketsmighthavebeenreactingto donotethequalifyingphrase,“ifthedisturbance somethingthatIdon’tsee—Iamnotinfalliblein continues.”Ifspreadsremainhigh,thentheeffect thesemattersandcertainlyhavemademyshare ontheeconomywillbesubstantial.Putmore ofmistakenjudgmentsinthepast.However,Ido precisely,thelongerthedisturbancecontinues, havetocallthingsasIseethemandIhavetried thegreaterwillbetheeffectontheeconomy.Iam togiveyouaveryopenopinionaboutmyassess- confidentthatinthesweepofhistorythedistur- ment.Thefundamentalsoftheeconomyarestrong bancewillbetemporary,butIdonotknowtoday becausetheinflationenvironmentisbenign— whether“temporary”meansamatterofafew inflationhasbeenstabletodecliningandinflation moreweeksoramatterofafewmoremonths. expectationsarethatinflationwillremainbenign. So,clearlyweattheFederalReserveneedtowatch Thelaborforceisfullyemployed. thissituationcloselyandtoadjustmonetarypolicy Iwantespeciallytoemphasizethatthebank- inlinewithourbestcurrentestimateoftheprob- ingsystemisstrong;increasesinbankcapital ableeffectsofthefinancialmarketbehavioron overrecentyearshavemeantthatbanklosses thegeneraleconomy. fromsomerecentloansthathavegonebaddonot Letmeemphasizemypersonalconviction threatenthesolvencyofthebanks.Bankcapital thatweneedtofocusontheeconomyitselfand isdoingexactlywhatitissupposetodo.This notaimoursightsatthefinancialmarketsperse. situationisquitedifferentfromthatintheearly TheFederalReservehasonlyonepolicyinstru- 1990swhenwedidhavearatherprolonged ment,whichistheamountofmoneyitcreates. periodofcreditstringencyrelatedingoodpart Asatacticalmatter,theFedsetsanoperating totheweaknessofbankcapitalatthattime. targetforthefederalfundsrate.Withonepolicy Insum,IbelievethattheU.S.economyisin instrument,theFedcanatbestbesuccessfulin asstrongapositionimaginabletowithstandthe pursuingonepolicyobjective.Inmyview,that suddenburstofriskaversionthathasaffected objectiveoughttobetheperformanceoftheU.S. thecreditmarketssincemidAugustintheper- economy,andmostespeciallyalowandstable vasivewayIhavebeendiscussingtonight.Ihave rateofinflation.Noaspectoftheperformanceof triedtounderstandwhatisgoingoninthecredit thefinancialmarketsshoulditselfbeapolicy marketsbydrawingonacombinationofeconomic objective,giventhattheFedhasonlyonepolicy theoryandhistoricalexperience.Ibelievethat instrument,buttheFedshould,inmyview,do theFed’spolicyresponsetothissituation,empha- thebestitcaninassessinghowfinancialmarkets sizingitspossibleeffectsontheU.S.economy, mayaffecttheeconomy.Induetime,andcon- hasbeenfullyappropriate.That’smymessage.It ceivablyquitequickly,thecurrentfinancialdis- willbeinterestingindeedtoseehowthesecon- turbancewillpeterout,andthenmyjobwillbe ditionsevolveinthemonthsahead. todothebestIcaninfiguringouttheeconomy’s directiongiventheresumptionofnormalcredit flows. 6

William Poole (1998, October 25). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19981026_poole

@misc{wtfs_speech_19981026_poole,
  author = {William Poole},
  title = {Speech},
  year = {1998},
  month = {Oct},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19981026_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}