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Money and financial markets.

Short-term Treasury yields plummeted immediately after the September 11 terrorist attacks and have declined further since then, at least for maturities longer than three months. Much of the initial decrease showed that actual and anticipated cuts in the target federal funds rate had already been priced in. Stock indexes also performed fairly well after dropping steeply the first week after the New York Stock Exchange reopened.

Yields on longer-term Treasuries fell less precipitously than short-term rates during the week after the attacks. In fact, the 30-year Treasury yield is now about the same as it was before September 11. Longer-term Treasury yields recently bounced up after the Treasury sold $6 billion in 10-year notes in an unscheduled auction on October 5. This apparently relieved a supply scarcity that was leading to an inordinate number of failed trades in the repo market.

The yield curve, which assumed its conventional upward slope almost a year ago, has been steepening over the past several months. A steepening yield curve often is viewed as a prelude to economic recovery, but it is unclear whether this scenario will play out. With inflation pressures apparently under control, speculation about renewed government debt financing may be buoying long-term yields.

Euro futures are used to hedge against funds rate movements, especially at longer maturities where they are more heavily traded than federal funds futures. Year-end forecasts of the funds rate implied by euro futures declined both before and after September 11. Throughout the past two months, however, market participants have continued to expect that rates would begin rising sometime early next year.

Corporate bond yields spiked for several weeks after the attacks but have since moved down, approaching their pre-September 11 levels. Companies reportedly found it unusually difficult to raise financing in the debt markets without offering premium interest rates. This was how Ford Motor Co. was able to issue $9.4 billion in debt on October 22, the largest corporate debt issuance to date.

The spread between AAA corporate bond yields and BAA corporate bond yields has widened somewhat since September 11, but by then the spread already had been widening for almost two years. Companies that are rated below investment grade--airlines being perhaps the most highly publicized--continue to be downgraded at a higher rate than investment-grade firms. After plunging in the week following the attacks, airline bonds stabilized and even rebounded slightly. Prices of insurance companies' bonds dropped less dramatically and are beck to their pre-September 11 levels. The airline industry is relatively worse off in that added cost pressures are joined with reduced travel demand.

Growth rates of monetary aggregates, both broad and narrow, surged during September in the wake of the terrorist attacks. M3 spurted as asset owners accumulated transaction deposits and shifted into both retail and institutional money funds. The Federal Reserve supplied an enormous increase in bank reserves. The extraordinary scale of that action can be seen by comparing excess reserves (reserves not needed to meet reserve requirements) supplied during September 2001 to those supplied in the months leading up to the century date change. Estimates show October excess reserves and the monetary base reverting to more normal levels as the Fed drains excess reserves from the banking system.

However, October data still do not show monetary policy exerting much of an effect on the monetary aggregates. Recent cuts in the fed funds rate will lead to reductions in their opportunity costs, so money growth will probably accelerate. So far, though, the increase in excess money growth (the excess or actual money over that predicted by a money demand model adjusted for the 1990s shift in velocity) has not been reflected in rising inflationary pressures.

Many stock market indexes have rebounded after declining sharply following September 11. However, a broad stock market decline had begun long before that as the result of weakening economic conditions. By one measure, the stock market now is fairly valued. If consumers consider stock market gains in making spending decisions--a debatable assumption--the market's decline may affect future consumption adversely.

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Publication:Economic Trends
Article Type:Brief Article
Geographic Code:1USA
Date:Nov 1, 2001
Previous Article:Monetary policy.
Next Article:The U.S. trade balance.

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