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The U.S. Credit Markets: Is the Trauma Over?
St. Louis Society of Financial Analysts
Missouri Athletic Club
St. Louis, MIssouri
January 21, 1999

F

or the economist interested in financial
markets, the period since August of last
year has been one of the most interesting over the last 50 years or more. The
Russian default in mid-August set off a series of
market adjustments that I find puzzling—indeed,
amazing. That there were impacts on emerging
markets was not so surprising, but the greatly
enlarged spread between U.S. Treasury bonds
and Aaa bonds issued by U. S. corporations was
truly a surprise to me, and I believe to almost all
economists. Market participants were also taken
aback by these events.
Consider some of the other manifestations of
this disturbance to the financial markets:
• The U.S. equity market declined substantially from mid-August to mid-October.
• The volume of new issues in the bond and
equity markets plummeted.
• Spreads, measured relative to short-term
U.S. Treasuries, widened substantially in
both the CD and commercial paper markets.
• Spreads between on-the-run and off-therun issues in the Treasury market rose
significantly.
In short, the disturbance was large, widespread
across markets, and persistent for a significant
period of time. My purpose today is to review
what has happened and to speculate on how we
can understand these unusual events. I spoke on
the same topic last October, and so my remarks
today are to a degree an update on the picture I
saw back then. I will discuss the trauma of the
early weeks after August of last year, and the
healing process in the markets starting, perhaps,

in mid-October. I then want to reflect on the types
of events that surprise the markets and create the
problems we observed. Finally, I will discuss the
critical role of a strong banking system in helping
the economy deal with the market upset.
Before I get further along, let me emphasize
that the views I express here are my own. Trying
to understand the markets is a difficult process,
and not everyone may share my interpretation.
Thus, my remarks do not necessarily reflect official
views of the Federal Reserve System.

THE TRAUMA
Let’s begin by reviewing what happened after
the middle of last August. When Russia announced
it was rescheduling its debts, the U.S. markets
reacted quickly. Yields on Treasury bonds of all
maturities declined. Yields on corporate bonds
in the United States rose relative to Treasuries;
the increase in yield spreads was greater the lower
the quality of the bonds. Spreads for high-yield
bonds—often called “junk bonds”—rose the most.
Aaa bond spreads rose the least, but nevertheless
significantly.
Figure 1 tells the story for Aaa bonds. By
showing the period since 1959, with the shaded
areas representing recessions, we can obtain an
appropriate perspective on what happened. The
spread of the Aaa yield over the 10-year Treasury
yield rose to the highest level shown over this
entire period. Note that the spread typically rises
during periods of recession; that outcome makes
perfect sense as corporate earnings decline in
recession, reducing the earnings coverage of interest payments and increasing the riskiness of the
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FINANCIAL MARKETS

Figure 1
Quality Spreads in the U.S. Bond Market
(monthly, January 1959–January 1999)

Aaa bonds relative to Treasuries. But last fall there
was no recession in the United States. Although
a few forecasters expected a recession in 1999,
the prevailing view was that the economy would
continue to grow, albeit at a slower rate than in
1998. I regard the greatly increased spread for
the highest-rated U.S. corporate bonds as a truly
remarkable effect flowing from the Russian
default. Although the Baa spread did not reach
unprecedented levels, the increase in that spread
was nevertheless substantial and the size of the
spread remains high even today.
Figure 2 shows that the Aaa spread rose primarily as a consequence of the decline in the
Treasury yield rather than from an increase in
the Aaa yield itself. In the markets for lower-rated
bonds, the spread rose both because Treasury
yields fell and because corporate bond yields
rose. This fact is readily apparent from Figure 2.
Although the uptick in the Baa yield was minor,
the yield increases were more substantial for
junk bonds.
2

Figure 3 shows what happened to the issuance
of new bonds. By October of last year, the flow of
financing in the bond market was less than half
the average monthly volume earlier in the year.
Many firms that had planned to come to market
postponed or cancelled their bond issues. They
judged that the cost was too high, certainly relative to their expectation that the markets would
settle down in due time. As these charts show,
this expectation has yet to be fully justified.
Spreads have indeed narrowed somewhat since
October, and the volume of new issues did rise in
November before settling back again in December.
Everyone is familiar with the significant
decline in the stock market from its July peak to
its double bottom in early September and early
October. That decline amounted to approximately
20 percent according to broad stock price indexes,
and considerably more for indexes covering
smaller firms. The stock market, you will recall,
was unusually volatile during the several months
after August. Public offerings in the equity market

The U.S. Credit Markets: Is the Trauma Over?

Figure 2
U.S. Long-Term Interest Rates
(monthly, January 1959–January 1999)

Figure 3
Volume of New Corporate Bond Issues
(public offerings, monthly, January 1995–December 1998)

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Figure 4
Certificate of Deposit Spread
(3-month CD less 3-month Treasury bill, monthly)

Figure 5
Commercial Paper Spread
(3-month nonfinancial CP less 3-month Treasury bill, monthly)

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The U.S. Credit Markets: Is the Trauma Over?

declined significantly, more or less tracking
experience for new issues in the bond market.
Merger and acquisition activity all but ceased.
At the short end of the fixed-income market,
spreads also rose significantly. Figures 4 and 5
show spreads in the CD and commercial paper
markets over a period of years. Today, these
spreads are back to the levels prevailing in the
months before August of last year.
Finally, within the Treasury market, yields for
off-the-run issues rose relative to those for on-therun issues. Trading is concentrated at the 5-, 10-,
and 30-year maturities—these are the so-called
“on-the-run” issues. At one point last October,
the 30-year Treasury bond was trading 35 basis
points less than the 29-year Treasury bond. Before
August, this spread was more commonly 5 to 7
basis points. Apparently, traders’ hunger for liquidity was so great that they were willing to hold
the 30-year bond even though its yield was far
below the 29-year bond. Quite frankly, I do not
understand why liquidity in the 30-year bond
would be so important to anyone, because it makes
no sense to me that traders should park funds
temporarily in such a long maturity.
In sum, the generality of the disturbance in
the credit markets was remarkable. I don’t think
it is an exaggeration to refer to these events in
the credit markets last fall as “traumatic.” The
effects were large, widespread across markets
and sustained for a period of quite some weeks.
In fact, the episode is not yet completely over.

THE HEALING PROCESS
The charts show that the healing process
began in October. Spreads narrowed across all of
these markets and the volume of new issues rose.
The CD and commercial paper spreads were back
to normal by mid November. By late November,
the stock market was back to its July peak. Spreads
have remained on the high side in the corporate
bond market, but the volume of new issues has
picked up.
What happened, I believe, is pretty straightforward. The healing process is a normal market

phenomenon. Investors began to look at the high
spreads and concluded that the risks were lower
than the compensation offered in the marketplace.
Corporate bonds began to look like bargains relative to Treasuries. The improved receptivity of
the market place led corporate treasurers to bring
new issues to the market. The Russian default did
not spread to other emerging markets, increasing
investor confidence that the situation would not
unravel in a serious way. And, of course, the
Federal Reserve reduced the intended federal
funds rate on three occasions, providing further
reassurance to the market that the Fed would provide any necessary liquidity support to ensure
that the overall economy remained healthy.
This view of the healing process is certainly
supported by the way markets have responded
recently to the Brazilian problems that led to the
depreciation of the real (the Brazilian currency
unit) against the dollar. Investors have taken the
Brazil situation in stride. The puzzle to me is not
the market reaction to Brazil this month but the
reaction to Russia last August. How can we understand which events surprise the markets and
which do not?

WHAT SURPRISES THE MARKETS?
The Russian default in mid-August clearly
did surprise most market participants. We know
that to be the case because Russian bonds would
have been trading at much lower prices prior to
the default if the market had widely expected
the default.
Why should the Russian default have been
such a shock to the market? My impression long
before the default was that the press was full of
reports disclosing the fundamental weakness of
the Russian position. President Boris Yeltsin and
the Russian parliament were at loggerheads,
Yeltsin’s health was unsteady and there was no
visible sign of progress on government finances.
Reports about the continuing large budget deficit
in Russia included stories about large numbers
of unpaid bills, including salaries for military
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officers. With Russian reform stalled, it seemed
obvious to me that a fiscal crisis was brewing.
When I have raised these observations with
market participants in private conversations, the
answer I get is that the market developed a sense
of euphoria about Russian prospects. Those who
invested in Russian stocks and bonds pointed to
continuing privatization of the Russian economy
and the great opportunities in the transition
from a centralized to a market economy. The
International Monetary Fund was heavily involved
in lending to the Russian government and in
assisting with the transition. It seems that confidence in Russia was so great that most market
participants simply brushed off reports of the
lack of progress by the Russian government. The
magnitude of the market upset provides the most
convincing evidence for just how unprepared
market participants were for an event such as
the Russian default.
Looking back, as painful as market reactions
to the default have been, a constructive feature
of this situation is that market participants began
to take a hard look at a wide range of investments
around the world, including in the United States.
It is not surprising that emerging market investments were given special scrutiny. But the changed
outlook extended deep into U.S. markets as well.
The reassessment included, as I have emphasized,
even the Aaa bond market. In this period of great
uncertainty and reexamination, a tremendous
hunger for liquidity led to the dramatically wider
spread between on-the-run and off-the-run
Treasuries.
The Russian default and its aftermath make
clear the dangers of complacency. Market participants and policymakers should be constantly
asking themselves “what if” questions about all
sorts of things. Having a plan of attack for every
contingency we can think of prepares us for dealing with the contingencies we do not think of,
which often are the ones that actually arise.
In economic terms, the Brazilian situation is
potentially much more serious for the United
States than the Russian situation, but the market
has responded in a measured way to Brazil. I
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suspect that the differing responses reflect widespread contingency thinking after Russia. Competitive markets ought always to respond in the
well-informed way they have responded to Brazil.
The fact that they do not always respond this way
is a matter of concern to me as a policymaker and
a matter of mystery to me as a social scientist.
What are policymakers supposed to do when
they become convinced that certain markets are
displaying too little awareness of the risks inherent in the situation? My observation is that jawboning by policymakers is likely to be ignored, or
produce unpredictable results, or may be simply
a wrongheaded view of any particular situation.
Not a promising set of possibilities, that’s for sure!
I think that my most constructive contribution as
a policymaker is to concentrate on getting the
fundamentals of Fed policy right, as best I can,
trusting that the markets will eventually take
care of themselves just fine.

THE CRITICAL ROLE OF A
STRONG BANKING SYSTEM
One of the Fed’s responsibilities is to supervise and examine banks. A sound banking system
contributes greatly to a strong economy. An important fact about last fall—a fact too little appreciated—is that the banking system did indeed play
a major role in defusing the credit-market trauma.
Banks were not themselves seriously affected by
the trauma. Some, to be sure, lost money on the
Russian default and from the problems facing
Long Term Capital Management Corporation.
Long Term Capital, you may recall, found itself
in trouble because the generalized nature of the
credit-market problems made lots of its bets go
sour at the same time. But bank solvency was
not threatened. Think about the nature of the
crisis we would have had if a number of moneycenter banks had been in trouble at the same time.
Clearly, strong bank capital going into the
Russian default was an element of great strength
for the economy. Banks themselves deserve much
of the credit for their strong capital positions, but

The U.S. Credit Markets: Is the Trauma Over?

we big bad policymakers certainly had something
to do with it.
Not only did banks not aggravate the credit
trauma, they also have had a lot to do with easing
the economy out of the problem. Some of the
firms that could not borrow as they had planned
in the securities markets turned to banks. Many
observers have pointed to this phenomenon to
explain recent rapid growth in bank credit. Banks
had the inherent capacity to fill the gap; accommodative Federal Reserve policy permitted and
encouraged banks to do so.

ENDPIECE
I’ll finish by recapping my argument. First,
the trauma in the credit markets touched off by
the Russian default was significant. When we
examine charts of historical data we realize just
how large the disturbance was. What we saw was
not a mere ripple, not business as usual.
Second, standard market processes are well
along in taking care of the problem. The healing
process is not yet complete, but I think there is
good reason to believe that the whole episode
will be history in a matter of weeks.

Third, a sound banking system played an
important role. Avoiding a banking problem
isolated the trauma to the securities markets, and
the banks offset a significant part of the effects of
the trauma on many individual firms.
The economy is coming through this very
unusual period that began last August in pretty
good shape. There are downward pressures in
certain sectors—especially agriculture, some parts
of manufacturing, oil production—that are independent of the credit-market trauma I’ve been
discussing. Fortunately, these sectors are a relatively small part of the total economy. Full revival
in these sectors may have to await a stronger
international economy.
The self-healing process within the securities
markets, the strength of the banking system and
the Fed’s timely response have prevented the
credit trauma from having serious negative effects
on the real economy. The episode is not totally
closed as yet, but I think it fair to say from everything we know that the Russian default and its
fallout are rapidly passing from an active policy
concern into the realm of historical interest only.

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Revised Figure 3
Volume of New Corporate Bond Issues
(public offerings, monthly, January 1995–December 1998)

POSTSCRIPT: FEBRUARY 25, 1999
The data for Figure 3 were revised in midFebruary 1999. What we thought had happened
in late 1998—the sharp decline in new bond
issuance—did not in fact happen. The table below
reports the data used in the original version of
Figure 3 and the revised data. Data used in
Figure 3:

October 1998

Original

Revised

$32.569 billion

$55.092 billion

November 1998

51.655

88.310

December 1998

28.170

57.540

This illustrates why policymakers need to
collate information from a wide variety of sources
in assessing the economic situation. Policymakers

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often must act on the basis of incomplete information, knowing the data are subject to revision. In
this case the revision was upward but, of course,
it might have gone the other way. I took up the
issue of data reliability, along with other issues,
in my speech entitled, “A Policymaker Confronts
Uncertainty” (presented to the St. Louis Gateway
Chapter, National Association for Business
Economics, St. Louis, Missouri—September 16,
1998). This speech is available on the St. Louis
Federal Reserve web site.