Speech

The U.S. Credit Markets: Is the Trauma Over? St.LouisSocietyofFinancialAnalysts MissouriAthleticClub St.Louis,MIssouri January21,1999 For the economist interested in financial inmid-October.Ithenwanttoreflectonthetypes markets, the period since August of last ofeventsthatsurprisethemarketsandcreatethe year has been one of the most interest- problemsweobserved.Finally,Iwilldiscussthe ing over the last 50 years or more. The criticalroleofastrongbankingsysteminhelping Russian default in mid-August set off a series of theeconomydealwiththemarketupset. marketadjustmentsthatIfindpuzzling—indeed, BeforeIgetfurtheralong,letmeemphasize amazing. That there were impacts on emerging thattheviewsIexpressherearemyown.Trying markets was not so surprising, but the greatly tounderstandthemarketsisadifficultprocess, enlarged spread between U.S. Treasury bonds andnoteveryonemaysharemyinterpretation. and Aaa bonds issued by U. S. corporations was Thus,myremarksdonotnecessarilyreflectofficial truly a surprise to me, and I believe to almost all viewsoftheFederalReserveSystem. economists. Market participants were also taken aback by these events. Considersomeoftheothermanifestationsof THE TRAUMA thisdisturbancetothefinancialmarkets: Let’sbeginbyreviewingwhathappenedafter • TheU.S.equitymarketdeclinedsubstan- themiddleoflastAugust.WhenRussiaannounced tiallyfrommid-Augusttomid-October. itwasreschedulingitsdebts,theU.S.markets • Thevolumeofnewissuesinthebondand reactedquickly.YieldsonTreasurybondsofall equitymarketsplummeted. maturitiesdeclined.Yieldsoncorporatebonds intheUnitedStatesroserelativetoTreasuries; • Spreads,measuredrelativetoshort-term theincreaseinyieldspreadswasgreaterthelower U.S.Treasuries,widenedsubstantiallyin thequalityofthebonds.Spreadsforhigh-yield boththeCDandcommercialpapermarkets. bonds—oftencalled“junkbonds”—rosethemost. • Spreadsbetweenon-the-runandoff-the- Aaabondspreadsrosetheleast,butnevertheless runissuesintheTreasurymarketrose significantly. significantly. Figure1tellsthestoryforAaabonds.By Inshort,thedisturbancewaslarge,widespread showingtheperiodsince1959,withtheshaded acrossmarkets,andpersistentforasignificant areasrepresentingrecessions,wecanobtainan periodoftime.Mypurposetodayistoreview appropriateperspectiveonwhathappened.The whathashappenedandtospeculateonhowwe spreadoftheAaayieldoverthe10-yearTreasury canunderstandtheseunusualevents.Ispokeon yieldrosetothehighestlevelshownoverthis thesametopiclastOctober,andsomyremarks entireperiod.Notethatthespreadtypicallyrises todayaretoadegreeanupdateonthepictureI duringperiodsofrecession;thatoutcomemakes sawbackthen.Iwilldiscussthetraumaofthe perfectsenseascorporateearningsdeclinein earlyweeksafterAugustoflastyear,andthe recession,reducingtheearningscoverageofinter- healingprocessinthemarketsstarting,perhaps, estpaymentsandincreasingtheriskinessofthe 1 FINANCIALMARKETS Figure 1 Quality Spreads in the U.S. Bond Market (monthly,January1959–January1999) AaabondsrelativetoTreasuries.Butlastfallthere Figure3showswhathappenedtotheissuance wasnorecessionintheUnitedStates.Although ofnewbonds.ByOctoberoflastyear,theflowof afewforecastersexpectedarecessionin1999, financinginthebondmarketwaslessthanhalf theprevailingviewwasthattheeconomywould theaveragemonthlyvolumeearlierintheyear. continuetogrow,albeitataslowerratethanin Manyfirmsthathadplannedtocometomarket 1998.Iregardthegreatlyincreasedspreadfor postponedorcancelledtheirbondissues.They thehighest-ratedU.S.corporatebondsasatruly judgedthatthecostwastoohigh,certainlyrela- remarkableeffectflowingfromtheRussian tivetotheirexpectationthatthemarketswould default.AlthoughtheBaaspreaddidnotreach settledowninduetime.Asthesechartsshow, unprecedentedlevels,theincreaseinthatspread thisexpectationhasyettobefullyjustified. wasneverthelesssubstantialandthesizeofthe Spreadshaveindeednarrowedsomewhatsince spreadremainshigheventoday. October,andthevolumeofnewissuesdidrisein Figure2showsthattheAaaspreadrosepri- NovemberbeforesettlingbackagaininDecember. marilyasaconsequenceofthedeclineinthe Everyoneisfamiliarwiththesignificant Treasuryyieldratherthanfromanincreasein declineinthestockmarketfromitsJulypeakto theAaayielditself.Inthemarketsforlower-rated itsdoublebottominearlySeptemberandearly bonds,thespreadrosebothbecauseTreasury October.Thatdeclineamountedtoapproximately yieldsfellandbecausecorporatebondyields 20percentaccordingtobroadstockpriceindexes, rose.ThisfactisreadilyapparentfromFigure2. andconsiderablymoreforindexescovering AlthoughtheuptickintheBaayieldwasminor, smallerfirms.Thestockmarket,youwillrecall, theyieldincreasesweremoresubstantialfor wasunusuallyvolatileduringtheseveralmonths junkbonds. afterAugust.Publicofferingsintheequitymarket 2 TheU.S.CreditMarkets:IstheTraumaOver? Figure 2 U.S. Long-Term Interest Rates (monthly,January1959–January1999) Figure 3 Volume of New Corporate Bond Issues (publicofferings,monthly,January1995–December1998) 3 FINANCIALMARKETS Figure 4 Certificate of Deposit Spread (3-monthCDless3-monthTreasurybill,monthly) Figure 5 Commercial Paper Spread (3-monthnonfinancialCPless3-monthTreasurybill,monthly) 4 TheU.S.CreditMarkets:IstheTraumaOver? declinedsignificantly,moreorlesstracking phenomenon.Investorsbegantolookatthehigh experiencefornewissuesinthebondmarket. spreadsandconcludedthattheriskswerelower Mergerandacquisitionactivityallbutceased. thanthecompensationofferedinthemarketplace. Attheshortendofthefixed-incomemarket, Corporatebondsbegantolooklikebargainsrela- spreadsalsorosesignificantly.Figures4and5 tivetoTreasuries.Theimprovedreceptivityof showspreadsintheCDandcommercialpaper themarketplaceledcorporatetreasurerstobring marketsoveraperiodofyears.Today,these newissuestothemarket.TheRussiandefaultdid spreadsarebacktothelevelsprevailinginthe notspreadtootheremergingmarkets,increasing monthsbeforeAugustoflastyear. investorconfidencethatthesituationwouldnot Finally,withintheTreasurymarket,yieldsfor unravelinaseriousway.And,ofcourse,the off-the-runissuesroserelativetothoseforon-the- FederalReservereducedtheintendedfederal runissues.Tradingisconcentratedatthe5-,10-, fundsrateonthreeoccasions,providingfurther and30-yearmaturities—thesearetheso-called reassurancetothemarketthattheFedwouldpro- “on-the-run”issues.AtonepointlastOctober, videanynecessaryliquiditysupporttoensure the30-yearTreasurybondwastrading35basis thattheoveralleconomyremainedhealthy. pointslessthanthe29-yearTreasurybond.Before Thisviewofthehealingprocessiscertainly August,thisspreadwasmorecommonly5to7 supportedbythewaymarketshaveresponded basispoints.Apparently,traders’hungerforliq- recentlytotheBrazilianproblemsthatledtothe uiditywassogreatthattheywerewillingtohold depreciationofthereal(theBraziliancurrency the30-yearbondeventhoughitsyieldwasfar unit)againstthedollar.Investorshavetakenthe belowthe29-yearbond.Quitefrankly,Idonot Brazilsituationinstride.Thepuzzletomeisnot understandwhyliquidityinthe30-yearbond themarketreactiontoBrazilthismonthbutthe wouldbesoimportanttoanyone,becauseitmakes reactiontoRussialastAugust.Howcanweunder- nosensetomethattradersshouldparkfunds standwhicheventssurprisethemarketsand temporarilyinsuchalongmaturity. whichdonot? Insum,thegeneralityofthedisturbancein thecreditmarketswasremarkable.Idon’tthink itisanexaggerationtorefertotheseeventsin WHAT SURPRISES THE MARKETS? thecreditmarketslastfallas“traumatic.”The effectswerelarge,widespreadacrossmarkets TheRussiandefaultinmid-Augustclearly andsustainedforaperiodofquitesomeweeks. didsurprisemostmarketparticipants.Weknow Infact,theepisodeisnotyetcompletelyover. thattobethecasebecauseRussianbondswould havebeentradingatmuchlowerpricespriorto thedefaultifthemarkethadwidelyexpected THE HEALING PROCESS thedefault. WhyshouldtheRussiandefaulthavebeen Thechartsshowthatthehealingprocess suchashocktothemarket?Myimpressionlong beganinOctober.Spreadsnarrowedacrossallof thesemarketsandthevolumeofnewissuesrose. beforethedefaultwasthatthepresswasfullof TheCDandcommercialpaperspreadswereback reportsdisclosingthefundamentalweaknessof tonormalbymidNovember.BylateNovember, theRussianposition.PresidentBorisYeltsinand thestockmarketwasbacktoitsJulypeak.Spreads theRussianparliamentwereatloggerheads, haveremainedonthehighsideinthecorporate Yeltsin’shealthwasunsteadyandtherewasno bondmarket,butthevolumeofnewissueshas visiblesignofprogressongovernmentfinances. pickedup. Reportsaboutthecontinuinglargebudgetdeficit Whathappened,Ibelieve,isprettystraight- inRussiaincludedstoriesaboutlargenumbers forward.Thehealingprocessisanormalmarket ofunpaidbills,includingsalariesformilitary 5 FINANCIALMARKETS officers.WithRussianreformstalled,itseemed suspectthatthedifferingresponsesreflectwide- obvioustomethatafiscalcrisiswasbrewing. spreadcontingencythinkingafterRussia.Com- WhenIhaveraisedtheseobservationswith petitivemarketsoughtalwaystorespondinthe marketparticipantsinprivateconversations,the well-informedwaytheyhaverespondedtoBrazil. answerIgetisthatthemarketdevelopedasense Thefactthattheydonotalwaysrespondthisway ofeuphoriaaboutRussianprospects.Thosewho isamatterofconcerntomeasapolicymakerand investedinRussianstocksandbondspointedto amatterofmysterytomeasasocialscientist. continuingprivatizationoftheRussianeconomy Whatarepolicymakerssupposedtodowhen andthegreatopportunitiesinthetransition theybecomeconvincedthatcertainmarketsare fromacentralizedtoamarketeconomy.The displayingtoolittleawarenessoftherisksinher- InternationalMonetaryFundwasheavilyinvolved entinthesituation?Myobservationisthatjaw- inlendingtotheRussiangovernmentandin boningbypolicymakersislikelytobeignored,or assistingwiththetransition.Itseemsthatconfi- produceunpredictableresults,ormaybesimply denceinRussiawassogreatthatmostmarket awrongheadedviewofanyparticularsituation. participantssimplybrushedoffreportsofthe Notapromisingsetofpossibilities,that’sforsure! lackofprogressbytheRussiangovernment.The Ithinkthatmymostconstructivecontributionas magnitudeofthemarketupsetprovidesthemost apolicymakeristoconcentrateongettingthe convincingevidenceforjusthowunprepared fundamentalsofFedpolicyright,asbestIcan, marketparticipantswereforaneventsuchas trustingthatthemarketswilleventuallytake theRussiandefault. careofthemselvesjustfine. Lookingback,aspainfulasmarketreactions tothedefaulthavebeen,aconstructivefeature ofthissituationisthatmarketparticipantsbegan THE CRITICAL ROLE OF A totakeahardlookatawiderangeofinvestments STRONG BANKING SYSTEM aroundtheworld,includingintheUnitedStates. Itisnotsurprisingthatemergingmarketinvest- OneoftheFed’sresponsibilitiesistosuper- mentsweregivenspecialscrutiny.Butthechanged viseandexaminebanks.Asoundbankingsystem outlookextendeddeepintoU.S.marketsaswell. contributesgreatlytoastrongeconomy.Animpor- Thereassessmentincluded,asIhaveemphasized, tantfactaboutlastfall—afacttoolittleappreci- eventheAaabondmarket.Inthisperiodofgreat ated—isthatthebankingsystemdidindeedplay uncertaintyandreexamination,atremendous amajorroleindefusingthecredit-markettrauma. hungerforliquidityledtothedramaticallywider Bankswerenotthemselvesseriouslyaffectedby spreadbetweenon-the-runandoff-the-run thetrauma.Some,tobesure,lostmoneyonthe Treasuries. Russiandefaultandfromtheproblemsfacing TheRussiandefaultanditsaftermathmake LongTermCapitalManagementCorporation. clearthedangersofcomplacency.Marketpartici- LongTermCapital,youmayrecall,founditself pantsandpolicymakersshouldbeconstantly introublebecausethegeneralizednatureofthe askingthemselves“whatif”questionsaboutall credit-marketproblemsmadelotsofitsbetsgo sortsofthings.Havingaplanofattackforevery souratthesametime.Butbanksolvencywas contingencywecanthinkofpreparesusfordeal- notthreatened.Thinkaboutthenatureofthe ingwiththecontingencieswedonotthinkof, crisiswewouldhavehadifanumberofmoney- whichoftenaretheonesthatactuallyarise. centerbankshadbeenintroubleatthesametime. Ineconomicterms,theBraziliansituationis Clearly,strongbankcapitalgoingintothe potentiallymuchmoreseriousfortheUnited Russiandefaultwasanelementofgreatstrength StatesthantheRussiansituation,butthemarket fortheeconomy.Banksthemselvesdeservemuch hasrespondedinameasuredwaytoBrazil.I ofthecreditfortheirstrongcapitalpositions,but 6 TheU.S.CreditMarkets:IstheTraumaOver? webigbadpolicymakerscertainlyhadsomething Third,asoundbankingsystemplayedan todowithit. importantrole.Avoidingabankingproblem Notonlydidbanksnotaggravatethecredit isolatedthetraumatothesecuritiesmarkets,and trauma,theyalsohavehadalottodowitheasing thebanksoffsetasignificantpartoftheeffectsof theeconomyoutoftheproblem.Someofthe thetraumaonmanyindividualfirms. firmsthatcouldnotborrowastheyhadplanned Theeconomyiscomingthroughthisvery inthesecuritiesmarketsturnedtobanks.Many unusualperiodthatbeganlastAugustinpretty observershavepointedtothisphenomenonto goodshape.Therearedownwardpressuresin explainrecentrapidgrowthinbankcredit.Banks certainsectors—especiallyagriculture,someparts hadtheinherentcapacitytofillthegap;accom- ofmanufacturing,oilproduction—thatareinde- modativeFederalReservepolicypermittedand pendentofthecredit-markettraumaI’vebeen encouragedbankstodoso. discussing.Fortunately,thesesectorsarearela- tivelysmallpartofthetotaleconomy.Fullrevival inthesesectorsmayhavetoawaitastronger internationaleconomy. ENDPIECE Theself-healingprocesswithinthesecurities I’llfinishbyrecappingmyargument.First, markets,thestrengthofthebankingsystemand thetraumainthecreditmarketstouchedoffby theFed’stimelyresponsehavepreventedthe theRussiandefaultwassignificant.Whenwe credittraumafromhavingseriousnegativeeffects examinechartsofhistoricaldatawerealizejust ontherealeconomy.Theepisodeisnottotally howlargethedisturbancewas.Whatwesawwas closedasyet,butIthinkitfairtosayfromevery- notamereripple,notbusinessasusual. thingweknowthattheRussiandefaultandits Second,standardmarketprocessesarewell falloutarerapidlypassingfromanactivepolicy alongintakingcareoftheproblem.Thehealing concernintotherealmofhistoricalinterestonly. processisnotyetcomplete,butIthinkthereis goodreasontobelievethatthewholeepisode willbehistoryinamatterofweeks. 7 FINANCIALMARKETS Revised Figure 3 Volume of New Corporate Bond Issues (publicofferings,monthly,January1995–December1998) POSTSCRIPT: FEBRUARY 25, 1999 oftenmustactonthebasisofincompleteinforma- tion,knowingthedataaresubjecttorevision.In ThedataforFigure3wererevisedinmid- thiscasetherevisionwasupwardbut,ofcourse, February1999.Whatwethoughthadhappened itmighthavegonetheotherway.Itookupthe inlate1998—thesharpdeclineinnewbond issueofdatareliability,alongwithotherissues, issuance—didnotinfacthappen.Thetablebelow inmyspeechentitled,“APolicymakerConfronts reportsthedatausedintheoriginalversionof Uncertainty”(presentedtotheSt.LouisGateway Figure3andthereviseddata.Datausedin Chapter,NationalAssociationforBusiness Figure3: Economics,St.Louis,Missouri—September16, 1998).ThisspeechisavailableontheSt.Louis Original Revised FederalReservewebsite. October1998 $32.569billion $55.092billion November1998 51.655 88.310 December1998 28.170 57.540 Thisillustrateswhypolicymakersneedto collateinformationfromawidevarietyofsources inassessingtheeconomicsituation.Policymakers 8

William Poole (1999, January 20). Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/speech_19990121_poole

@misc{wtfs_speech_19990121_poole,
  author = {William Poole},
  title = {Speech},
  year = {1999},
  month = {Jan},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/speech_19990121_poole},
  note = {Retrieved via When the Fed Speaks corpus}
}