1. Asset valuation
Valuation pressures remain elevated in some markets
Equity prices relative to forecast earnings remain above their long-run median, and yields on corporate bonds are near historically low levels. However, measures of investor appetite for risk that take into account the low level of long-term Treasury yields are broadly in line with historical norms for equity and safer corporate bonds, while they are still somewhat elevated for high-yield bonds and leveraged loans. CRE and farmland prices are elevated relative to rents and incomes in these sectors. By contrast, residential real estate (RRE) prices are roughly in line with their long-run relation to rents on a national basis.
Table 1 shows the size of the asset markets discussed in this section. The largest asset markets are those for RRE, corporate equities, and CRE.
Table 1. Size of Selected Asset Markets
(billions of dollars)
|Residential real estate
|Commercial real estate
|Investment-grade corporate bonds
|High-yield and unrated corporate bonds
|Leveraged loans *
|Price growth (real)
|Commercial real estate **
|Residential real estate ***
Note: The data extend through 2019:Q2. Growth rates are measured from Q2 of the year immediately preceding the period through Q2 of the final year of the period. Equities, real estate, and farmland are at market value; bonds and loans are at book value.
* The amount outstanding shows institutional leveraged loans and generally excludes loan commitments held by banks. For example, lines of credit are generally excluded from this measure. Average annual growth of leveraged loans is from 2000 to 2019:Q2, as this market was fairly small before then.
** One-year growth of commercial real estate prices is from June 2018 to June 2019, and average annual growth is from 1998:Q4 to 2019:Q2. Both growth rates are calculated from value-weighted nominal prices deflated using the consumer price index.
*** One-year growth of residential real estate is from June 2018 to June 2019, and average annual growth is from 1997:Q4 to 2019:Q2. Nominal prices are deflated using the consumer price index.
Source: For leveraged loans, S&P Global Market Intelligence, Leveraged Commentary & Data; for corporate bonds, Mergent, Inc., Corporate Fixed Income Securities Database; for farmland, Department of Agriculture; for residential real estate price growth, CoreLogic; for commercial real estate price growth, CoStar Group, Inc., CoStar Commercial Repeat Sale Indices (CCRSI); for all other items, Federal Reserve Board, Statistical Release Z.1, "Financial Accounts of the United States."
Yields in Treasury markets are very low...
Yields on longer-dated Treasury securities are at their lowest levels in decades (figure 1-1). Since the previous Financial Stability Report, yields on Treasury securities have fallen across the maturity spectrum, spurred by concerns about risks to the global growth outlook and declines in policy expectations in the United States and abroad. Consistent with the safety role of longer-term Treasury securities, estimates of Treasury term premiums are near the lowest level of the past 20 years (figure 1-2).5 Forward-looking measures of Treasury market volatility derived from options prices remain low by historical standards, consistent with investors expecting Treasury yields to stay near current levels for some time (figure 1-3).
. . . as are yields on corporate bonds, while spreads on high-yield bonds remain somewhat compressed
Yields on corporate bonds are also very low, in line with very low Treasury yields (figure 1-4). The spread between yields on investment-grade corporate bonds and yields on Treasury securities is close to its long-run median.6 By contrast, the spread between yields on high-yield corporate bonds and yields on Treasury securities is narrower than its long-run median (figure 1-5). Other measures also suggest that investors' appetite for riskier corporate bonds remains strong. For instance, the excess bond premium, measured as the gap between bond spreads and expected credit losses and inversely related to investor risk appetite, lies below its median (figure 1-6).7
Investor demand for leveraged loans remains strong, albeit below the levels seen in 2018. The interest rate spread on higher-rated leveraged loans is below its historical median, although the spread on lower-rated loans is close to its median and above the very tight level of last year, consistent with weakening demand for this class of loans (figure 1-7). Lending standards and loan covenants have generally remained weak but have recently been tightening for lower-rated loans.
Equity prices are high relative to corporate earnings, consistent with low interest rates
Over the past couple of years, equity prices have been high relative to forecasts of corporate earnings (figure 1-8). However, other measures of investors' risk appetite in domestic equity markets are in the middle of their historical ranges. The gap between the forward earnings-to-price ratio and the expected real yield on 10-year Treasury securities—a rough measure of the premium investors require for holding corporate equities—is well above its long-run median (figure 1-9). A measure of expected equity return volatility over the next 30 days implied by option prices remains low (figure 1-10).
Liquidity in U.S. Treasury and equity futures markets deteriorated
"Market liquidity" refers to the cost of buying or selling securities quickly. Market liquidity conditions deteriorated in U.S. Treasury and equity futures markets amid separate episodes of elevated volatility in May and August. The box "What Has Been Happening to the Liquidity of U.S. Treasury and Equity Futures Markets?" provides additional information about these developments.
What Has Been Happening to the Liquidity of U.S. Treasury and Equity Futures Markets?
"Market liquidity" refers to the cost of quickly buying or selling a desired quantity of a security. Liquid markets support financial stability. Poor market liquidity exacerbates price volatility and may hinder the ability of investors and institutions to adjust positions, adversely affecting the ability of the financial system to adjust to shocks. In this discussion, we examine how liquid markets currently are, how fragile this liquidity is, and whether the risk of "flash events"—sudden, large changes in asset prices that are then reversed—has increased. We focus on two important markets: the interdealer U.S. Treasury security market and the E-mini S&P 500 futures market.
U.S. Treasury and equity futures market liquidity has recently deteriorated
Measuring market liquidity is challenging because liquidity has several dimensions. Some measures that capture different dimensions of market liquidity include the bid-ask spread, quoted depth, and price impact. The bid-ask spread is the difference between the best price offer to buy a security, which is the "bid," and the best price offer to sell, which is the "ask." In very competitive and liquid markets, the spread, or difference between the bid and ask prices, is small. Quoted depth is the quantity of an asset available to buy or sell at the posted bid and offer prices. Markets that are more liquid have greater quoted depth. Price impact is how much a security price changes for a given amount bought or sold. Markets are liquid when traders can sell larger quantities without triggering outsized price drops. For simplicity, the following analysis combines these three measures into a single index of illiquidity, which is higher when bid-ask spreads are wider, quoted depth is smaller, and trades have a greater effect on price.1
Figure A shows the illiquidity index for 2-, 5-, and 10-year U.S. Treasury notes from 2005 to the present, along with the Merrill Lynch Option Volatility Estimate, or MOVE, index, a measure of implied interest rate volatility. Illiquidity increased notably during the financial crisis and quickly declined thereafter. Illiquidity also rose around the 2013 taper tantrum and the October 15, 2014, flash rally as well as in August 2019. In other words, Treasury security illiquidity is higher when Treasury yields are more volatile. This relationship holds true in most markets. To the extent that asset price volatility reflects asset value uncertainty and the riskiness of providing liquidity, intermediaries either need to pull back as a way of managing the risk or need to charge more for providing liquidity as compensation for bearing the risk. This withdrawal and the increase in compensation for risk make trading more expensive, increasing illiquidity. Nonetheless, the relationship between U.S. Treasury illiquidity and interest rate volatility seems roughly stable over time, suggesting that liquidity has not become more fragile.
Figure B shows the illiquidity index for the E-mini S&P 500 futures contract, along with the CBOE Volatility Index (VIX). Illiquidity spiked during the financial crisis and, more recently, rose in early 2018, late 2018, and August 2019, coinciding with increases in the VIX. As with Treasury securities, equity illiquidity is higher when asset price volatility is higher. In contrast to U.S. Treasury securities, the relationship between the two appears to have changed since 2018, with illiquidity since then unusually high relative to its past relationship to volatility. This change suggests that liquidity has become more fragile over time—it tends to disappear when it is needed the most, when asset price volatility is high.
Flash events appear to have become modestly more frequent in equity futures
A possible implication of a deterioration in market liquidity is a greater incidence of flash events, in which prices move abruptly and sizably and then quickly revert. Indeed, such flash events have received significant attention from the press in recent years. Flash events may undermine confidence in trading venues and financial markets even if the price dislocations are short lived. Price dislocations, particularly if they occur at the end of a trading session, could trigger mark-to-market losses among a range of market participants. Finally, trading is increasingly connected across markets, so flash events in one market could affect trading and liquidity in other markets.
As shown in figure C, the number of flash events rose sharply during the crisis and then quickly declined. Recently, the number of flash events increased modestly in equity futures (the red bars) but not in the Treasury market (the blue bars).2
To learn more, we asked dealers for their opinions
The September 2019 Senior Credit Officer Opinion Survey on Dealer Financing Terms asked dealers whether equity futures market liquidity has increased or decreased, on average, or become more fragile, in addition to inquiring about the causes of any changes. Consistent with the evidence shown in this discussion, dealers responded that, compared with January 2018, liquidity in the equity futures market has deteriorated and become more fragile. Survey respondents cited several reasons, including higher volatility, decreased willingness of principal trading firms (PTFs) and non-PTFs to provide liquidity, and an increase in the concentration of firms that provide liquidity.3 The box "Salient Shocks to Financial Stability Cited in Market Outreach" discusses other shifts in market structure that could render market liquidity more vulnerable to shocks.
1. The indexes are calculated for each market as the first principal components of the standardized individual liquidity measures. The first principal components capture 60 to 85 percent of the variation in the individual measures. Return to text
2. We identify flash events as five-minute returns that exceed 10 standard deviations in magnitude (positive or negative, based on all five-minute returns from 2005 to the present) and that then revert by at least two-thirds of the size of the initial jump within the next 12 hours. Return to text
3. A PTF is defined as a principal investor who deploys proprietary low-latency automated trading strategies and who may be registered as a broker-dealer but does not have clients as in a typical broker-dealer business model; see U.S. Department of the Treasury, Board of Governors of the Federal Reserve System, Federal Reserve Bank of New York, U.S. Securities and Exchange Commission, and U.S. Commodity Futures Trading Commission (2015), Joint Staff Report: The U.S. Treasury Market on October 15, 2014 (Washington: Department of the Treasury, Board of Governors, FRBNY, SEC, and CFTC, July), https://www.treasury.gov/press-center/press-releases/Documents/Joint_Staff_Report_Treasury_10-15-2015.pdf. Return to textReturn to text
CRE prices are high relative to rents...
CRE prices have increased substantially over the past seven years (figure 1-11). By contrast, commercial property rents have generally risen more slowly. As a result, capitalization rates, which measure annual rental income relative to prices for recently transacted commercial properties, have moved down over the past decade and are at historically low levels, little changed since mid-2017 (figure 1-12). This year, the spread of capitalization rates over yields on 10-year Treasury securities, which is a rough measure of the premium that investors require for holding CRE over safe alternative investments, has risen from low levels to above its median over the past decade, as the decline in Treasury yields this year has not been accompanied by an acceleration in CRE prices (figure 1-13). Data from the Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) collected in July and October indicated that CRE lending standards were tightened, on net, in the second and third quarters (figure 1-14). They remained at the tighter end of the range that has prevailed since 2005.
. . . and farmland prices are falling from recent historical highs...
Although they have recently moved down from their peaks, farmland prices, both nationally and in several midwestern states, remain high by historical standards (figure 1-15). Farmland prices also remain high relative to rents (figure 1-16). Net farm income continues to be well below the high levels seen in the early years of the past decade, reflecting low agricultural commodity prices and trade tensions.
. . . while home prices are growing moderately and are consistent with rents
House prices have risen substantially since 2012, although increases in home prices have slowed noticeably this year and, nationwide, recent levels of home prices appear broadly in line with rents (figure 1-17). For instance, while the aggregate housing price-to-rent ratio is higher than its long-run historical trend, this implied gap is small (figure 1-18). However, housing price-to-rent ratios vary significantly across regional markets, and price-to-rent ratios for cities that have seen rapid price increases are still above their usual ranges (figure 1-19).
5. Treasury term premiums capture the difference between the yield that investors require for holding longer-term Treasury securities—for which realized returns are more sensitive to risks from future inflation or volatility in interest rates than the realized returns of shorter-term securities—and the expected yield from rolling over shorter-dated ones. Return to text
6. Spreads between yields on corporate bonds and comparable-maturity Treasury securities reflect the extra compensation investors require to hold debt that is subject to corporate default or liquidity risks. Return to text
7. For a description of the excess bond premium, see Simon Gilchrist and Egon Zakrajšek (2012), "Credit Spreads and Business Cycle Fluctuations," American Economic Review, vol. 102 (June), pp. 1692–720. Return to text