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Whither the U.S. Credit Markets?
Construction Financial Managers Association
Co-sponsored by the Associated Builders and Contractors and the Builders Exchange
Louisville, Kentucky
October 26, 1998


am delighted to be here this evening to
meet with the Construction Financial
Managers Association at this meeting cosponsored by the Associated Builders and
Contractors and the Builders Exchange. I had
originally planned to provide an overview of the
state of the economy but decided instead to concentrate on the very unusual situation in today’s
credit markets. I think this decision is fully appropriate given that interest rates and credit availability are critical issues for all parts of the construction industry.
The U.S. financial landscape changed dramatically in mid-August of this year. Initially, what we
saw was a dramatic widening of quality spreads
as lower-rated corporate bonds fell in yield relative
to Treasury bonds. In the ensuing weeks we found
that the number of new bonds coming to market
fell dramatically from the pace earlier in the year.
In addition, the stock market became much more
volatile and on average equity prices declined. As
in the bond market, the number of new issues coming into the equity market declined substantially.
What I want to do this evening is to discuss
in some detail what has happened in the credit
markets and to work on providing a deeper understanding of these events and of their possible
implications for the U.S. economy.

Let me begin this discussion by referring to
Figure 1 reporting corporate bond spreads monthly
from 1959 to date. The bold line in the figure
shows the spread of the Aaa average bond yield

over the ten-year Treasury yield. The daily average
of that spread was about 185 basis points so far
in October, compared with an average over the
entire period since 1959 of 68 basis points. The
figure also reveals that the spread in today’s market is indeed higher than we have seen since 1959.
The lighter line in Figure 1 shows the spread
of lower-rated corporate securities—those carrying
a Baa rating—over the 10-year Treasury yield. So
far in October that spread has averaged 265 basis
points. As we can see from the figure, this spread
is higher than normal—the average over the entire
period is 167 basis points. However, a spread this
large is not all that uncommon since 1959.
We should also compare the current spreads
to their recent levels before August. Over the past
several years, the Aaa spread has been in the
neighborhood of 100 basis points and the Baa
spread has been in the neighborhood of 150 basis
points. So, clearly the spreads have increased
sharply since August and that is the phenomenon
we need to understand and that monetary policy
makers need to confront. At this point, I want to
put aside policy discussion; we must look much
more carefully at understanding the situation
before we discuss the policy response.
The vertical shaded areas in the figure show
periods of recession as defined by the National
Bureau of Economic Research. In almost all cases
historically, spreads widened only after a recession
was clearly underway. Such behavior makes perfectly good sense as periods of recession bring
declining corporate earnings and less earnings
coverage of corporate debt service. The effect is
more important, of course, for lower-rated bonds
such as the Baa bonds. With increased risk of


Figure 1
Corporate Bond Spreads

default, investors demand higher yields. Moreover, in general we can observe that the increase
in the spread is greater the deeper the recession.
The recessions of 1973-75 and 1981-82 were more
serious than the other recessions shown in the
figure, and the peak spreads were higher. If we
go back further in U.S. history, we would observe
exactly the same thing.
Many observers have commented on figures
similar to Figure 1, although to my taste they too
often concentrate on only the last few years with
the consequence that the lessons from history
are missed.
I now want to turn to a different way of looking at this same subject by examining the absolute
levels of the yields. Figure 2 provides the information we need. The bold line in the figure shows
the 10-year Treasury bond yield. As we can see,
that yield has dropped dramatically in recent
months. The Aaa and Baa yields have also fallen
somewhat, although not as much. Therefore, the

spread that has opened up is quantitatively more
a consequence of the steep decline in the Treasury
yield than a consequence of an increase in the
Aaa or Baa yields. If we look at the lower-rated
bonds the market refers to as “junk” bonds, the
story is broadly the same except that the junkbond yields have gone up in absolute value so
that the spread has become quite large. Based on
the Merrill Lynch high-yield bond series, this
spread averaged 566 basis points in September
compared with more recent experience in 1997
and 1998 until August of a spread closer to 300
basis points.
We can tell a broadly similar story at the
short-end of the market. The spread between the
yields on bank CDs relative to the three-month
Treasury bill rate has opened up to the tune of
142 basis points for the week ending October 16
compared with an average spread over the period
since 1964 of 81 basis points. This year before
August the spread was closer to 60 basis points.

Whither the U.S. Credit Markets?

Figure 2
Long-Term Bond Yields

Thus the CD spread has increased by something
in the order of 80 basis points since August. What
this means is that the cost of purchased funds to
large banks has risen substantially relative to the
Treasury bill rate.
The commercial paper rate has also risen relative to the Treasury bill rate. In mid-October that
spread was about 127 basis points compared with
an average spread since 1971 of 71 basis points.
The average spread this year before August was
more in the neighborhood of 50 basis points,
which means that the commercial paper spread
has risen by something in the order of 80 basis
points since August, or about the same as the
increase in the CD spread. Thus the cost of financing to the large corporations that utilize the commercial paper market has risen by 80 basis points
relative to the Treasury bill rate. Here again, as
in the bond market, the absolute cost of financing
in the CD and commercial paper markets has not
gone up; the spreads have widened because the
T-bill rate has gone down substantially.

Spreads do not tell the entire story. I don’t have
the volume numbers at my fingertips, but it is
evident that the number of new issues has declined
quite substantially. To what extent volume is
down because potential borrowers simply cannot
place riskier bonds due to weak demand for such
bonds and to what extent volume is down because
potential borrowers are simply waiting for spreads
to narrow I do not know. Either way, the sharply
reduced volume is another measure of the magnitude of the current disturbance in the credit
Finally, because of the wide reporting of the
stock market, everyone is familiar with the
declines in the equity market and the greatly
increased volatility in that market. The increased
volatility is indeed quite dramatic; we have all
experienced the gut-wrenching up and downs—
the downs hit deeper in the gut than the ups—in
the stock market.


One other thing that has happened—little
noted by the general public, but much commented
upon by market professionals—is the spread that
has opened up within the Treasury bond market
between on-the-run and off-the-run issues. For
example, the longest bond outstanding, which
has a maturity of a little less than 30 years, was
recently trading at a yield of about 35 basis points
less than the next longest bond. That spread narrowed somewhat last week. Ordinarily, this yield
difference is in the neighborhood of five to eight
basis points. The same phenomenon can be seen
when comparing 10-year and 9-year T-bonds, and
5-year and 6-year T-bonds. The market liquidity
is far higher for the on-the-run issues at 5, 10, and
30 years than for the neighboring bonds. For some
reason, the market concentrates on those particular
maturities. Finally, bid-asked spreads for any given
issue in the Treasury market have also widened.
It seems reasonable to interpret these yield
spreads within the Treasury market as providing
a measure of the market’s tremendous hunger for
liquidity and the market’s tremendous uncertainty.
The on-the-run issues can be traded in much
larger volume and with a much lower bid-asked
spread—although a higher bid-asked spread than
normal—than the neighboring issues, so these are
the issues where market professionals place funds
on a temporary basis. It may seem strange that
traders would use a thirty-year bond as a place
to park funds temporarily, but that seems to be
the way the market works.
So, to summarize, throughout the credit markets we see evidence of a very large change in
investors’ attitudes starting in mid-August. The
equity markets are on average down and much
more volatile. Quality spreads have opened up
substantially in the bond market and in the money
market. The volume of new issues in both the
equity market and the bond market has declined
very substantially. Within the Treasury bond market, off-the-run issues trade at much higher than
usual yields relative to on-the-run issues. And
bid-asked spreads throughout the bond market,
including the Treasury bond market, are higher
than normal.

Now that we have reviewed what has happened in the credit markets, let’s talk a bit about
trying to understand these events. I already commented briefly that in the bond market, as you
can see from the figures I distributed, the spreads
historically have been related to recessions. I also
commented that it makes perfect sense for spreads
to widen under such circumstances. One possible
interpretation of the increased spreads today is
that a recession has already started. That possibility seems remote to me, as the current economic
data simply do not point to an actual decline in
economic activity already in place. The most
recent data suggest that the rate of growth has
slowed a bit, but not that the overall economy is
already on a downward track. Moreover, most
forecasters are calling for continued expansion
next year, although there are a few who believe a
recession is on the way.
My personal observation on a recession forecast is that if a recession does start early next year,
the circumstances surrounding it will be unique
in U.S. business cycle history. As far as I know,
looking back on the entire chronology of recessions starting in the 1850s, there is no case in
which the period leading up to a recession was
characterized by low-to-declining inflation,
declining interest rates well in advance of the
cycle peak, and high-and-rising money growth.
I’ve learned not to say that something is impossible
in this business, but we must form our judgments
from our experience and to me it seems unlikely
that a recession is either already underway or just
around the corner.
When we look at the spreads at the short end
of the market—the CD and commercial paper
spreads—we can observe two features of our experience since 1959. First, the spreads are characterized for the most part by short, sharp peaks.
Second, we can identify specific events that triggered the sharp increases in the spreads. It is useful to recount these specific events to understand
better what is going on.

Whither the U.S. Credit Markets?

In 1970, the Penn-Central Railroad declared
bankruptcy. Penn-Central had issued commercial
paper which the rating agencies had rated prime.
Holders of prime commercial paper issued by
other corporations were understandably taken
aback when they heard of the Penn-Central
default. Their reaction was perfectly natural and
understandable: they asked whether other commercial paper rated prime might also be suspect.
The immediate effect was a sharp increase in the
commercial paper spread over T-bills as investors
insisted on a higher yield to protect themselves.
Before very long, however, the market sorted out
the borrowers that truly were prime from others
that were more questionable. The questionable
borrowers were no longer able to borrow at prime
and the prime borrowers borrowed at a normal
spread over the T-bill rate. The hiccup in the
market disappeared quickly.
Similar disturbances that resulted in sharply
increased spreads can be identified. The Franklin
National Bank failed in 1974, Continental Illinois
Bank nearly failed in 1984, and the stock market
crashed in 1987. In all these cases we observe
spikes in spreads in the CD and commercial paper
markets. But the key point is that in a chart the
spreads look like spikes rather than long plateaus
at the times of these events. In these cases I’ve
mentioned, and others, the market straightened
out the matter quite literally in a matter of weeks.
This time, the disturbance has lasted somewhat longer so far than similar disturbances in the
past. The shock to the markets was a particular
piece of news—the Russian default on its debt in
mid August, or debt rescheduling for those who
want to be polite and strictly accurate. Apparently,
the Russian situation led many investors to think
much more carefully about risks in the marketplace and to wonder whether spreads were adequate to cover those risks.
We really do not know how long spreads
will remain high and the volume of new issues
abnormally low; the current experience is more
general and pervasive than the examples we see
in history. But my own personal guess is that the
market today is well into the process of sorting
out the solid credits from the less solid ones.

There are straws in the wind suggesting that the
flows of financing through the markets are picking
up once again and that we are headed back toward
a more normal state of affairs. Spreads have narrowed a bit in recent days, and the stock market
is up significantly from its lows. But, I do want
to emphasize that my observations reflect straws
in the wind, and I would not personally be surprised if the situation either lasts longer or sorts
itself out quickly. Put another way, there is necessarily a wide variance to any reasonable forecast about this matter.
Now let me try to put these observations in a
somewhat general framework. Here is how the
process works as best I can understand it. Some
shock or piece of news hits the market and takes
people by surprise. Many investors run for cover
until they can sort out the situation. Investors
move away from more risky securities and park
funds temporarily in safe, highly liquid Treasury
securities. However, the wide spreads that open
up provide the incentive to the markets to sort out
the problem quickly. After all, if you can invest
in a slightly risky security at a spread over a
Treasury security that more than amply compensates for the risk, then why not go for it? The
market is in the business of assessing risks and
obtaining the highest possible yield consistent
with the risk being assumed. So, while the market
in general may be dominated for a few weeks by
highly risk-adverse investors, more astute and
adventurous investors will start to place funds
in the securities that offer a high yield relative to
the risk involved. This process gradually spreads
to the rest of the market, and not always so gradually. That is why the figure on the spread shows
spikes rather than long plateaus.
I haven’t mentioned bank lending as yet,
because not much has happened on that front.
The information I have indicates that large banks
may have pulled back a bit, looking harder at the
riskiness of potential loans and shying away from
some they would have accepted before August.
However, most small- and medium-sized banks
have continued their lending policies largely


It is pretty obvious that if the spreads remain
high for an extended period of time, and if the
flow of new credit to borrowers who would have
readily qualified for funds only a short time ago
remains largely cut off, then the economy will
almost certainly slow substantially. But, please
do note the qualifying phrase, “if the disturbance
continues.” If spreads remain high, then the effect
on the economy will be substantial. Put more
precisely, the longer the disturbance continues,
the greater will be the effect on the economy. I am
confident that in the sweep of history the disturbance will be temporary, but I do not know today
whether “temporary” means a matter of a few
more weeks or a matter of a few more months.
So, clearly we at the Federal Reserve need to watch
this situation closely and to adjust monetary policy
in line with our best current estimate of the probable effects of the financial market behavior on
the general economy.
Let me emphasize my personal conviction
that we need to focus on the economy itself and
not aim our sights at the financial markets per se.
The Federal Reserve has only one policy instrument, which is the amount of money it creates.
As a tactical matter, the Fed sets an operating
target for the federal funds rate. With one policy
instrument, the Fed can at best be successful in
pursuing one policy objective. In my view, that
objective ought to be the performance of the U.S.
economy, and most especially a low and stable
rate of inflation. No aspect of the performance of
the financial markets should itself be a policy
objective, given that the Fed has only one policy
instrument, but the Fed should, in my view, do
the best it can in assessing how financial markets
may affect the economy. In due time, and conceivably quite quickly, the current financial disturbance will peter out, and then my job will be
to do the best I can in figuring out the economy’s
direction given the resumption of normal credit


Let me finish with a few observations on the
current economic situation. The fundamentals
of the U.S. economy really do seem to me to be
sound. I am not trying to sound optimistic in an
effort to calm the market, or for any other purpose.
Such a stance wouldn’t work for the Fed for more
than a few days if the flow of news reflects fundamentals that are not really sound. It is true that
the credit markets might have been reacting to
something that I don’t see—I am not infallible in
these matters and certainly have made my share
of mistaken judgments in the past. However, I do
have to call things as I see them and I have tried
to give you a very open opinion about my assessment. The fundamentals of the economy are strong
because the inflation environment is benign—
inflation has been stable to declining and inflation
expectations are that inflation will remain benign.
The labor force is fully employed.
I want especially to emphasize that the banking system is strong; increases in bank capital
over recent years have meant that bank losses
from some recent loans that have gone bad do not
threaten the solvency of the banks. Bank capital
is doing exactly what it is suppose to do. This
situation is quite different from that in the early
1990s when we did have a rather prolonged
period of credit stringency related in good part
to the weakness of bank capital at that time.
In sum, I believe that the U.S. economy is in
as strong a position imaginable to withstand the
sudden burst of risk aversion that has affected
the credit markets since mid August in the pervasive way I have been discussing tonight. I have
tried to understand what is going on in the credit
markets by drawing on a combination of economic
theory and historical experience. I believe that
the Fed’s policy response to this situation, emphasizing its possible effects on the U.S. economy,
has been fully appropriate. That’s my message. It
will be interesting indeed to see how these conditions evolve in the months ahead.