INTEREST RATES
As the year began, with worries related to the century date change out of the way, participants in the fixed-income market turned their attention to the signs of con-tinued strength in domestic labor and product markets, and they quickly priced in the possibility of a more aggressive tightening of monetary policy. Both private and Treasury yields rose considerably. In the latter part of January, however, Treasury yields plummeted, especially those on longer-dated securities, as the announced de-tails of the Treasury’s debt buyback program and upwardly revised forecasts of federal budget surpluses led investors to focus increasingly on the prospects for a diminishing supply of Treasury securities. A rise in both nominal and inflation-indexed Treasury yields in response to strong economic data and tighter monetary policy in April and May was partly offset by supply factors and by occasional safe haven flows from the volatile equity market. Since late May, market interest rates have declined as market participants have interpreted the incoming economic data as evidence that monetary policy might not have to be tightened as much as had been previously expected. On balance, while Treasury bill rates and yields on shorter-dated notes have risen 15 to 80 basis points since the beginning of the year, intermediate- and long-term Treasury yields have declined 5 to 55 basis points. In the corporate debt market, by contrast, bond yields have risen 10 to 70 basis points so far this year.
Forecasts of steep declines in the supply of longer-dated Treasuries have combined with tighter monetary policy conditions to produce an inverted Treasury yield curve, starting with the two-year maturity. In contrast, yield curves else-where in the U.S. fixed-income market generally have not inverted. In the interest rate swap market, for instance, the yield curve has remained flat to upward sloping for maturities as long as ten years, and the same has been true for yield curves for the most actively traded corporate bonds. Nonetheless, private yield curves are flatter than usual, suggesting that, although supply considerations have played a potentially important role in the inversion of the Treasury yield curve this year, in-vestors’ forecasts of future economic conditions have also been a contributing fac-tor. In particular, private yield curves are consistent with forecasts of a modera-tion in economic growth and expectations that the economy will be on a sustainable, non-inflationary track, with little further monetary policy tightening.
The disconnect between longer-term Treasury and private yields as a conse-quence of supply factors in the Treasury market is distorting readings from yield spreads. For instance, taken at face value, the spread of BBB corporate yields over the yield on the ten-year Treasury note would suggest that conditions in the corpo-rate bond market so far in 2000 are worse than those during the financial market turmoil of 1998. In contrast, the spread of the BBB yield over the ten-year swap rate paints a very different picture, with spreads up this year but below their peaks in 1998. Although the swap market is still not as liquid as the Treasury secu-rities market, and swap rates are occasionally subject to supply-driven distortions, such distortions have been less pronounced and more short-lived than those affect-ing the Treasury securities market of late, making swap rates a better benchmark for judging the behavior of other corporate yields.
Aware that distortions to Treasury yields are likely to become more pro-nounced as more federal debt is paid down, market participants have had to look for alternatives to the pricing and hedging roles traditionally played by Treasuries in U.S. financial markets. In addition to interest rate swaps, which have featured prominently in the list of alternatives to Treasuries, debt securities issued by the three government-sponsored housing agencies–Fannie Mae, Freddie Mac, and the Federal Home Loan Banks–have been used in both pricing and hedging. The three housing agencies have continued to issue a substantial volume of debt this year in an attempt to capture benchmark status, and the introduction in March of futures and options contracts based on five- and ten-year notes issued by Fannie Mae and Freddie Mac may help enhance the liquidity of the agency securities market. None-theless, the market for agency debt has been affected by some uncertainty this year regarding the agencies’ special relationship with the government. Both the Treasury and the Federal Reserve have suggested that it would be appropriate for the Congress to consider whether the special standing of these institutions contin-ues to promote the public interest, and pending legislation would, among other things, restructure the oversight of these agencies and reexamine their lines of credit with the U.S. Treasury.
The implementation of monetary policy, too, has had to adapt to the antici-pated paydowns of marketable federal debt. Recognizing that there may be limita-tions on its ability to rely as much as previously on transactions in Treasury securi-ties to meet the reserve needs of depositories and to expand the supply of cur-rency, the FOMC decided at its March 2000 meeting to facilitate until its first meeting in 2001 the Trading Desk’s ability to continue to accept a broader range of collateral in its repurchase transactions. The initial approvals to help expand the collateral pool were granted in August 1999 as part of the Federal Reserve’s ef-forts to better manage possible disruptions to financial markets related to the century date change.
At the March 2000 meeting, the Committee also initiated a study to consider alternative asset classes and selection criteria that could be appropriate for the System Open Market Account (SOMA) should the size of the Treasury securities market continue to decline. For the period before the completion and review of such a study, the Committee discussed, at its May meeting, some changes in the management of the System’s portfolio of Treasury securities in an environment of decreasing Treasury debt. The changes aim to prevent the System from coming to hold high and rising proportions of new Treasury debt issues. They will also help the SOMA to limit any further lengthening of the average maturity of its portfolio while continuing to meet long-run reserve needs to the greatest extent possible through outright purchases of Treasury securities. The SOMA will cap the rollover of its existing holdings at Treasury auctions and will engage in secondary market purchases according to a schedule that effectively will result in a greater percent-age of holdings of shorter-term security issues than of longer-dated ones. The schedule ranges from 35 percent of an individual issue for Treasury bills to 15 per-cent for longer-term bonds. These changes were announced to the public on July 5, replacing a procedure in which all maturing holdings were rolled over and in which coupon purchases were spread evenly across the yield curve.
EQUITY PRICES
Major equity indexes have posted small gains so far this year amid considerable volatility. Fluctuations in technology stocks have been particularly pronounced: Af-ter having reached a record high in March–24 percent above its 1999 year-end value–the Nasdaq composite index, which is heavily weighted toward technology shares, swung widely and by mid-July was up 5 percent for the year. Given its surge in the second half of 1999, the mid-July level of the Nasdaq was about 60 percent above its mid-1999 reading. The broader S&P 500 and Wilshire 5000 indexes have risen close to 3 percent since the beginning of the year and are up about 10 percent and 13 percent, respectively, from mid-1999.
Corporate earnings reports have, for the most part, exceeded expectations, and projections of future earnings continue to be revised higher. However, the in-crease in interest rates since the beginning of the year likely has restrained the rise in equity prices. In addition, growing unease about the lofty valuations reached by technology shares and rising default rates in the corporate sector may have given some investors a better appreciation of the risks of holding stocks in general. Reflecting the uncertainty about the future course of the equity market, expected and actual volatilities of stock returns rose substantially in the spring. At that time, volatility implied by options on the Nasdaq 100 index surpassed even the ele-vated levels reached during the financial market turmoil of 1998.
Higher volatility and greater investor caution had a marked effect on public equity offerings. The pace of initial public offerings has fallen off considerably in recent months from its brisk first-quarter rate, with some offerings being can-celed or postponed and others being priced well short of earlier expectations. On the other hand, households’ enthusiasm for equity mutual funds, especially those funds that invest in the technology and international sectors, remains relatively high, although it appears to have faded some after the run-up in stock market vola-tility in the spring. Following a first-quarter surge, net inflows to stock funds mod-erated substantially in the second quarter but still were above last year’s average pace.
DEBT AND THE MONETARY AGGREGATES
DEBT AND DEPOSITORY INTERMEDIATION
The total debt of the U.S. household, government, and nonfinancial business sectors is estimated to have increased at close to a 5-1/2 percent annual rate in the first half of 2000. Outside the federal government sector, debt expanded at an annual rate of roughly 9-1/2 percent, buoyed by strength in household and business bor-rowing. Continued declines in federal debt have helped to ease the pressure on available savings and have facilitated the rapid expansion of nonfederal debt out-standing: The federal government paid down $218 billion of debt over the first half of 2000, compared with paydowns of $56 billion and $101 billion in the first six months of calendar years 1998 and 1999 respectively.
Depository institutions have continued to play an important role in meeting the strong demands for credit by businesses and households. Adjusted for mark-to-market accounting rules, credit extended by commercial banks rose 11-1/2 per-cent in the first half of 2000. This advance was paced by a brisk expansion of loans, which grew at an annual rate of nearly 13 percent over this period. Bank credit increased in part because some businesses sought bank loans as an alterna-tive to a less receptive corporate bond market. In addition, the underlying strength of household spending helped boost the demand for consumer and mortgage loans. Banks’ holdings of consumer and mortgage loans were also supported by a slower pace of securitizations this year. In the housing sector, for instance, the rising in-terest rate environment has kept the demand for adjustable-rate mortgages rela-tively elevated, and banks tend to hold these securities on their books rather than securitize them.
Banks have tightened terms and standards on loans further this year, espe-cially in the business sector, where some lenders have expressed concerns about a more uncertain corporate outlook. Bank regulators have noted that depository insti-tutions need to take particular care in evaluating lending risks to account for possi-ble changes in the overall macroeconomic environment and in conditions in securities markets.
THE MONETARY AGGREGATES
Growth of the monetary aggregates over the first h