May 10, 2006
JS-4248

Remarks of Treasury Under Secretary for
Domestic Finance Randal Quarles to the
Money Marketeers
New York, NY

Thank you.  It is a great pleasure to have this opportunity to speak before the Money Marketeers.  I'd like to use my time this evening to comment on the very positive economic developments over recent quarters and to offer some perspectives on risks in the financial sector that have garnered a great deal of media attention of late.

Economic Performance

First let me review the good news about the economy.  Recent economic performance by all accounts has been very strong and the economy appears poised to continue along a solid track of expansion.  After the lull in motor vehicle spending in the fourth quarter of last year associated with the expiration of special sales incentives in the fall, consumer spending rebounded in the first quarter of this year.  Moreover, indicators of household financial conditions are quite positive on net:  Delinquency rates on credit cards, mortgages and other consumer debt remain at quite low levels; household bankruptcies have dropped following the implementation of new bankruptcy legislation last fall; and household net worth relative to personal disposable income reached the highest point in several years near the end of last year and likely has climbed still further over the course of this year.  These developments coupled with strong employment gains, falling unemployment rates, and a more optimistic outlook for wage growth have buoyed consumer confidence despite elevated energy prices.

Developments in the business sector also point to continued solid economic expansion.  Spending on equipment and software accelerated last quarter, suggesting growing confidence among business executives about the underlying strength of the economy.  New orders for nondefense capital goods continue to exceed shipments.  And strong corporate profits, healthy balance sheets, and ample credit availability should continue to support business investment over coming quarters.  Moreover, businesses continue to discover new ways to streamline operations and create efficiencies.  Headline productivity in the nonfarm business sector advanced at a 3¼ percent pace last quarter.  Perhaps even more notably, productivity growth in the nonfinancial corporate sector averaged 5 percent last year--up a full percentage point from the prior year.  Those productivity increases have helped to keep cost pressures in check.  Indeed, unit costs in the nonfinancial corporate sector actually edged lower over the course of last year.  On balance, these results suggest that overall inflation pressures remain contained.  The most recent data on PCE prices point to core price inflation over the first quarter at about 2 percent.  The rise in the market-based core PCE index--which many view as a more accurate reading of underlying inflation as it excludes various imputed prices--has been  even more modest, running at about a 1¾ percent pace over the first quarter.

Strong U.S. economic performance over the past year has lifted all boats including a few that are docked at the U.S. Treasury.  In particular, tax receipts were very strong last month, far exceeding initial estimates.  At last count, individual nonwithheld tax receipts over this April/May period were the second highest on record and well above the level anticipated in the President's budget.  Corporate taxes have also exceeded initial estimates.  As a result, we remain on track to meet the President's goal of cutting the deficit in half by 2009.

In short, the hard work and dedication of the American workforce coupled with the President's economic program are paying off in superior economic performance.  Most economic forecasts are upbeat about economic prospects with inflation expected to remain low and output and employment projected to expand at a pace close to long-run trends.

Risks to the Outlook

Perhaps this would be an excellent note to end on, but I grew up on a ranch--which is surprisingly good training for thinking about markets--and learned at an early age that today's weather is not necessarily tomorrow's and that shocks can dramatically affect the outlook.  In that spirit, I would like to turn now to some of the factors that may present risks to the economic outlook.  We live in an uncertain world and there is certainly no shortage of potential risks that we face. 

One very significant risk that I have addressed previously is the question of the housing GSEs, Fannie Mae and Freddie Mac.  It is now widely recognized that the GSEs have relied upon their funding advantage to expand the size of their retained portfolios far beyond levels necessary to achieve their mission.  The concentration of risk inherent in these portfolios along with the GSEs' thin capital structure are an important policy concern and a high priority for the Treasury, and we are continuing to urge Congress to take action soon to address these issues. 

Today, however, I would like to focus on three other risks that have been widely noted--unusually low volatility and risk premiums in financial markets, elevated home prices and mortgage market developments, and foreign demands for U.S. Treasury securities.

• The Low Volatility and Low Risk Premiums

Low volatility and low risk premiums are the rule across financial markets in the current environment.  Realized volatilities in interest rate, credit, and equity markets have been near historical lows.  And forward-looking measures of uncertainty in these markets derived from options prices suggest that investors expect volatility to remain low for the foreseeable future.  At the same time, investors do not appear to be requiring much compensation for risk in many of these markets.  Compensation for default risk in the form of credit spreads for both high- and low-tier credits is quite low.  And compensation for interest rate risk as captured by term premiums in the Treasury and interest rate swap markets is similarly quite modest.  I would note that this pattern of low volatility and low risk premiums is a global phenomenon: Fixed-income and equity markets in other industrialized countries exhibit many of the same features.

So what should we make of this?  Is this just a transitory quiescent period or are there longer-run forces at work?  To some extent, low volatility and low risk premiums may be a function of longer-run trends.  At the outset of my remarks, I noted the reasons for optimism in the most recent U.S. economic data.  But taking a much longer view, macro economic performance has been steadily improving in the United States and elsewhere since the early 1980s in what economists have dubbed the "great moderation."  That is, the variability in output and inflation seems to be falling over time.  There have been many hypotheses offered as explanation for this trend including, among others, better monetary and fiscal policy, increased integration in world markets, technological change, and changes in the composition of production.  But whatever the root causes, it seems reasonable to conclude that greater stability in the underlying macroeconomy is a factor contributing to low volatility and risk premiums in financial markets.

As plausible as this explanation may be though, I suspect it is not the entire story.  While there have been genuine and far reaching advances in market practices, institutions, and regulatory infrastructure that have contributed to the stability of financial markets over the years, I'm afraid that human nature and psychology remain just as unpredictable as ever.  We know that financial markets are prone to sudden bouts of turbulence--witness the stock market crash in 1987, the "capital crunch" in the banking sector in the early 1990s, the steep rise in long-term interest rates in 1994, the global turmoil in the fall of 1998, the speculative bubble in tech stocks and its aftermath in 1999-2000, and the sharp withdrawal from risk-taking in 2002 amid corporate accounting scandals.  As much as one might hope that the current low volatility environment is permanent, it seems a fair bet to say that it will be interrupted from time to time by further financial crises large and small.  Accepting this fact, as policymakers we are constantly endeavoring to foster measures that can reduce the incidence of crises and improve our readiness to manage crises and to mitigate their effects when and if they occur.

What might such a crisis look like?  Every situation is unique of course, but recent history points to some common elements.  During these episodes, investors' perception of risk and their aversion to it seem to increase substantially.  Stock prices fall on major exchanges as investors mark down their expectations for earnings growth and require larger premiums for risk.  Safe-haven demands for Treasuries and other very high-grade instruments drive yields down in these markets, while interest rates on lower-tier credits increase markedly.  Realized and implied volatilities in fixed-income and equity markets rise.  Market-makers pare their risk positions and bid-ask spreads widen while market depth deteriorates.  Correlations among financial variables may depart substantially from historical relationships.  Banks and other lenders may tighten credit availability. And reductions in wealth and a fall in business and household confidence may threaten to impair spending.

How would our current financial system stand up to this sort of canonical crisis?  On the whole, I would say that the U.S. economy is well positioned to weather such a retrenchment in risk-taking.  If anything, there may be some elements of business credit markets that might be a question mark.  Credit spreads have narrowed very substantially over recent years and banks have eased their standards and terms on business loans significantly as well.  Of course, the banking sector as a whole is well capitalized, but losses on outstanding business loans and a significant tightening in the availability of new business credit could well develop in a crisis.  Given the rapid expansion in credit default swaps and in cash and synthetic collateralized debt obligations (CDOs) and some of the problems observed in these markets over recent quarters, one might speculate that these markets could be tested in an environment with significant numbers of defaults. Moreover, there could well be some fallout in the hedge fund sector as these institutions have been significant players in credit derivatives markets, often relying on leverage in implementing their strategies. 

Of course, hedge funds have received enormous attention over the last few years and I will be testifying before Congress on hedge funds next week.  Let me just say here as an aside that I do not subscribe to a view apparently held by some that hedge funds represent an imminent threat to financial stability.  To the contrary, hedge funds play an important role in price discovery and in supporting market liquidity.  As a general principle, I see the growth of hedge funds alongside other developments such as increasing cross-border holdings of securities as part of the larger evolution in financial markets toward the textbook ideal of "complete financial markets."  In that ideal world, investors enjoy ready access to a full range of securities that allow them to price and hedge risks in every conceivable state of the world.  Of course, we're a long way yet from that ideal--among other things, in the world of complete financial markets, all investors have full information about the range of investments at their disposal and the risks that they entail--but the flexibility that hedge funds enjoy in implementing their investment strategies is a step in that direction.  I think it is important that we have a clear understanding of the evolving role of hedge funds in our financial system, and I have asked Assistant Secretary Henry to undertake an initiative to learn more about developments and potential public policy issues in this important sector.  We will be hosting a series of informal discussions with market participants and other industry experts as part of that effort.

Finally, I would like to note that the Treasury Department along with other agencies has devoted considerable resources to both crisis prevention and crisis management.  Under the general heading of crisis prevention, we have been working with other agencies at home and abroad to foster sound risk management policies and practices throughout the financial system.  In the area of crisis management, we are again working in coordination with others in improving the resilience of the financial system.  We have conducted periodic crisis management exercises with other U.S. authorities and we have also been working closely with colleagues in international forums to improve communications and coordination in the event of a crisis.  You might also know that we recently published a white paper for public comment outlining a possible structure for a Treasury securities lending facility, which might be a useful additional tool for the Treasury in managing financial crises.

• Housing Prices and Potential Mortgage Payment Shocks

I'd like to turn now to a risk factor that is particularly close to home.  Open the local real estate section of many newspapers these days and one finds a mixture of giddiness and angst--giddiness over the escalation of home prices over recent years and angst that the boom in home prices may soon come to an end.  Some analysts have suggested that house prices in some markets could be substantially "overvalued."  However, considerable uncertainty surrounds such estimates.  In particular, analysts have debated whether biases in some standard house price series might account for a significant portion of the notable rise in price-to-rent ratios over recent quarters. 

Regardless of where one falls out in this debate, a broad-based decline in house prices would almost certainly exert a noticeable drag on economic activity.  Based on standard estimates relating wealth to spending, every 1 percent drop in house prices might translate to something on the order of a 0.1 percent drop in household spending over time.  Of course, these spending effects might be more pronounced if a fall in house prices were especially marked and occurred over a short time period.  Such a sharp decline in house prices would be very unusual and could well shake business and household confidence about economic prospects.  The decline in confidence, in turn, could depress spending by more than suggested by simple wealth effect calculations.  I have to say that I do not think this is a likely scenario.  Of course, it would not be at all surprising to see a moderation in the escalation of home prices, but I would not expect to see a substantial drop in housing prices as long as income is rising and interest rates remain moderate.

Another worry in housing markets centers on the rapid expansion of variable payment mortgages, which include standard ARMs and so-called non-traditional mortgages that may incorporate "interest-only" periods and other special features.  Regulatory agencies have expressed concerns that banks have been aggressively marketing such mortgages to a broad audience without taking full account of the risks involved.  To address these issues, the regulatory agencies issued draft guidance on non-traditional mortgages last December.  The guidance focused on three broad areas--underwriting standards, risk management practices, and consumer protection.  While I won't venture into all the details here, the draft guidance suggested that banks need to ensure that their underwriting standards take account of the borrower's ability to repay over the life of the loan, that their capital and loan loss provisions recognize that the performance of these loans has not been tested in a stressed environment, and that information provided to borrowers regarding the terms of non-traditional mortgages is understandable, timely, and accurately conveys the full range of risks associated with any particular mortgage product.

At the macro level, some reports have suggested that increases in mortgage payments under non-traditional mortgages may represent a substantial hit to household disposable income.  However, many households that have taken out interest-only mortgages, for example, appear to have opted for five- to ten-year interest-only payment periods.  As a result, only a relatively small portion of outstanding interest-only mortgages is expected to reprice over the next few years.  Market estimates suggest that the potential increase in mortgage payments in 2006 and 2007 from such repricing effects might total as much as $20 billion.  While that is certainly a large number, it represents only a small hit to aggregate personal income.  Moreover, market reports indicate that borrowers using such non-traditional mortgages tend to be upper income individuals that can manage a sizable increase in their monthly mortgage payment. 

• Foreign Holdings of Treasuries

I would like to turn now to another perceived risk that has received a fair amount of attention of late--the potential for large foreign investors to aggressively diversify away from U.S. Treasury securities. 

I have to say upfront that I find this scenario fairly implausible.  Foreign investors hold Treasuries because they are a safe and highly liquid instrument.  Still, foreign holdings of U.S. Treasuries are very substantial and foreign demands for Treasuries could certainly evolve over time. 

Taking this concern at face value, a broad-based shift in foreign portfolio demands away from Treasuries and toward other private securities should push Treasury yields higher and drive the yield on private securities lower. 

The key question is by how much?  Recalling basic supply and demand analysis, the answer to this question depends in part of the slope of the demand curve for Treasury securities.  If the demand curve is fairly steep, a leftward shift in the demand curve in conjunction with relatively unchanged supply could drive Treasury prices down substantially and push Treasury yields sharply higher.  On the other hand, if the demand curve for Treasuries is very flat, then the same leftward shift in the demand curve would have little or no impact on Treasury prices and yields.  It is difficult to identify the slope of the demand curve for Treasury securities with any great precision, but I would observe that the rapid increases in foreign holding of Treasury securities during 2003 and 2004 was accompanied by only a modest widening in spreads between swap or agency rates and Treasury yields. 

This evidence suggests to me that the demand curve for Treasuries is rather flat.  Consistent with this view, the reported dropoff in foreign demands for Treasuries of late has not resulted in any notable narrowing of these spreads.  On balance, I would not rule out the possibility that a very substantial portfolio shift away from Treasuries by foreign investors could put some upward pressure on yields, but I believe the effects would most likely be modest and temporary. 

I draw some confidence on this point from many conversations with market participants that have underscored the so-called "search for alpha" in fixed-income markets.  With a flat yield curve and the compression in risk spreads that I noted previously, these market participants have noted that it has become more difficult to generate the elevated risk-adjusted returns--the alpha-- that attracts investors.  In this sort of environment, I suspect that even a small drop in Treasury prices occasioned by a hypothetical falloff in foreign demands would be enough to spur legions alpha-hunters eager to acquire Treasuries at only slightly higher yields.

Conclusion

I would like to close by just noting that the potential tail risks I've talked about today are just that--possibilities but not likely outcomes.  Fundamentally, the economy is strong, the financial sector is healthy, and our future looks bright.  We will surely face challenges in the future, but we can take comfort in the knowledge that our economy and financial system have proven remarkably resilient to all manner of adverse shocks in the past.  And I can assure you that my colleagues and I at the Treasury are doing everything in our power to make our financial system even more resilient in the future.  Thank you.