1. Asset valuation
The severe deterioration in the economic outlook, with its associated increase in uncertainty and risk aversion, depressed valuations, increased volatility, and impaired market functioning
Beginning in late February, expectations for global economic growth plummeted and uncertainty increased sharply, driving down risky asset prices and putting downward pressure on Treasury yields. These movements were amplified by a decrease in investor appetite for risk amid deteriorating market conditions. For a time, markets were severely dislocated, with volatilities historically high and liquidity conditions severely strained.
During the most severe period of stress, equity prices fell sharply, outpacing the downward revisions to earnings forecasts; spreads on corporate bonds over comparable-maturity Treasury securities widened to record the highest daily levels since 2009; and leveraged loan spreads also widened, especially for lower-rated loans. Since late March, however, investor risk sentiment has improved, and risky asset prices have partially retraced earlier declines. Some of this improvement is likely due to strong and rapid fiscal and monetary policy responses as well as the measures taken by the Federal Reserve and Treasury described in the boxes (see the boxes "The Federal Reserve's Monetary Policy Actions and Facilities to Support the Economy since the COVID-19 Outbreak" and "Federal Reserve Tools to Lessen Strains in Global Dollar Funding Markets").
Property prices—including on commercial real estate (CRE), farmland, and residential real estate (RRE)—generally take more time to respond to sudden changes in economic activity but appear likely to come under pressure.
Asset prices remain vulnerable to significant declines should the pandemic worsen, the economic fallout prove more adverse, or financial system strains reemerge
The improvement in asset markets since their troughs reflects expectations for a rebound in economic activity as well as the extraordinary policy actions taken. Uncertainty remains high and markets remain volatile relative to historical norms, suggesting the possibility of further price declines should developments prove more adverse than expected. Price declines could be especially pronounced in areas where valuations have remained high and where asset values are sensitive to the pace of economic activity. CRE markets are an example, as prices were high relative to fundamentals before the pandemic, and disruptions in the hospitality and retail sectors have been severe.
Table 1 shows the size of the asset markets discussed in this section. The largest asset markets are those for corporate equities, RRE, CRE, and Treasury securities.
Table 1. Size of Selected Asset Markets
(billions of dollars)
|Average annual growth,
|Residential real estate||37,768||3.8||5.5|
|Commercial real estate||20,007||8||7.1|
|Investment-grade corporate bonds||5,949||4.1||8.4|
|High-yield and unrated corporate bonds||1,341||4.9||6.6|
|Price growth (real)|
|Commercial real estate **||4.6||2.6|
|Residential real estate***||1.4||2|
Note: The data extend through 2019:Q4. Growth rates are measured from Q4 of the year immediately preceding the period through Q4 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:Q4, as this market was fairly small before then.
** One-year growth of commercial real estate prices is from September 2018 to December 2019, and average annual growth is from 1998:Q4 to 2019:Q4. 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 September 2018 to December 2019, and average annual growth is from 1997:Q4 to 2019:Q4. 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; for all other items, Federal Reserve Board, Statistical Release Z.1, "Financial Accounts of the United States."
Yields in Treasury markets experienced elevated volatility, and market functioning was strained
Yields on longer-dated Treasury securities declined to very low levels (figure 1-1). Consistent with the safety role of longer-term Treasury securities, estimates of Treasury term premiums are at record lows (figure 1-2).3 Reflecting heightened uncertainty and realized volatility, a forward-looking measure of Treasury market volatility derived from options prices shot up from the subdued levels seen in the fall. The March average was at its highest level since 2008-09, but volatility has since come down considerably (figure 1-3).
As the effects of the COVID-19 pandemic on financial markets intensified, Treasury market functioning became unusually strained, and by mid-March there were indications of severe market dislocations. Even though overall trading volumes rose significantly, market depth for longer-dated securities in both Treasury cash and futures markets dropped to record-low levels, and average bid-ask spreads widened dramatically. One factor contributing to the severe distress may have been constraints on dealers' ability to expand their balance sheets to hold higher quantities of assets amid a wave of Treasury securities sales (see the box "Institutional Activities and Market Liquidity" for further discussion).4 Federal Reserve open market operations and regulatory actions reportedly helped offset some pressure on the balance sheets of dealers.5 Subsequently, market functioning difficulties receded, with bid-ask spreads in relatively liquid segments of the Treasury market returning to more typical levels. However, some measures, such as market depth, have shown only modest signs of improvement; this is particularly true for longer-dated tenors (figure 1-4).6
Corporate bond spreads widened substantially amid a deteriorating corporate earnings outlook and illiquidity
Yields on corporate bonds, although supported by very low Treasury yields, still increased in March from historically low levels (figure 1-5). Consequently, spreads of yields on corporate bonds over comparable-maturity Treasury yields widened substantially as investor risk appetite deteriorated (figure 1-6).7 Spreads widened particularly for firms in the energy, airline, and leisure industries, as the outlook for those industries deteriorated with the intensification of the COVID-19 pandemic.8 Other indicators also suggest a reduction in investor risk appetite. For example, the excess bond premium, measured as the gap between corporate bond spreads and expected credit losses and inversely related to investor risk appetite, rose well above its historical median (figure 1-7).9 Corporate bond market functioning was adversely affected as liquidity conditions deteriorated: Bid-ask spreads widened considerably for both investment-grade and high-yield bonds, and bond mutual funds and ETFs experienced large outflows. Liquidity conditions in those markets as well as investor risk appetite improved following the Federal Reserve's announcement of corporate credit facilities.
Investor demand for leveraged loans has also fallen since late February, leading to a notable widening of interest rate spreads at issuance for lower-rated leveraged loans (figure 1-8). Interest rate spreads for higher-rated leveraged loans also widened. However, the observed widening of spreads at issuance likely understates the deterioration in market conditions, as new issuance activity nearly came to a halt in March. Issuance of collateralized loan obligations (CLOs)—the largest investors in leveraged loans—slowed considerably, and loan mutual funds experienced sharp outflows on net. Liquidity conditions in the secondary market also deteriorated, with bid-ask spreads widening to their highest levels in a decade. Conditions have improved somewhat since late March.
Equity prices swung widely, and liquidity conditions deteriorated
Equity prices plunged as concern over the COVID-19 outbreak grew, reflecting declines in both investor appetite for risk and expected income. Equity prices relative to forecasts of corporate earnings also declined below the historical median (figure 1-9). However, prices relative to earnings forecasts have risen since late March to levels seen before the outbreak: Prices have increased a fair bit from their trough, and analysts' firm-level earnings forecasts have fallen in response to the economic deterioration. Other measures of investor risk appetite in domestic equity markets exhibited a similar pattern. 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 risky corporate equities—jumped close to historical highs in March, but it has since retraced about half of the increase (figure 1-10).
A measure of expected equity return volatility over the next 30 days implied by option prices surged to a record daily reading in mid-March, sending the March average to the highest level in more than a decade (figure 1-11). Liquidity conditions in equity cash and futures markets deteriorated significantly in late February amid heightened price volatility. Large price movements triggered circuit breakers several times in both equity spot and equity futures markets in March.10 Since late March, volatility has come down, but remains elevated relative to historical norms, and liquidity remains poor.
Prices of commercial properties and farmland were highly elevated relative to their income streams on the eve of the pandemic, suggesting that their prices could fall notably
CRE prices were elevated through February 2020, the most recent data point (figure 1-12). Commercial property rents have generally risen more slowly than prices over the past several years. As a result, capitalization rates, which measure annual rental income relative to prices for recently transacted commercial properties, have ranged around historically low levels (figure 1-13). 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, increased somewhat as Treasury yields declined (figure 1-14).
The vulnerability stemming from elevated CRE valuation pressures, coupled with a dim outlook for the sector as indicated by recent declines in equity real estate investment trust (REIT) prices, suggests that CRE may undergo a substantial repricing in response to disruptions generated by the COVID-19 pandemic. For instance, since late February, the hospitality and retail sectors have experienced precipitous declines in demand because of social distancing, putting the ability of these sectors to make timely mortgage and rental payments into question. The non-agency commercial mortgage-backed securities (CMBS) market, which had previously been funding about one-fifth of CRE mortgage debt, stopped new securitizations toward the end of March. CRE loans that would normally be securitized have been accumulating on bank balance sheets. In addition, data from the April 2020 Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS) indicated that a major fraction of banks reported weaker demand for CRE loans and tighter lending standards, on net, in the first quarter of 2020 (figure 1-15).
According to data through 2019, farmland prices, both nationally and in several midwestern states, had remained high by historical standards, although they moved down from earlier peaks (figure 1-16). Farmland prices also remain high relative to rents (figure 1-17). Net farm income is forecast to have increased in 2019 but 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 the available data predate the COVID-19 outbreak, the effect of COVID-19 on the agricultural supply chain has placed further downward pressure on already-stressed farm income.
House prices were somewhat elevated relative to rents before the COVID-19 outbreak
House prices have grown at a moderate pace for the past several quarters, and, nationwide, prices appear only a little above their long-run average relationship with property rents (figures 1-18 and 1-19). However, housing price-to-rent ratios vary significantly across regional markets, and price-to-rent ratios for some cities that have seen rapid price increases are elevated (figure 1-20).
The severe disruptions in economic activity following the outbreak could reduce house prices by bringing down household incomes and restricting access to mortgage credit. However, weakened demand may be partially offset by lower supply arising from slowdowns in the construction of new houses, and mortgage forbearance may help prevent an increase in distressed transactions that could otherwise put considerable downward pressure on house prices. It will take some time for house prices to show the effects, as these prices generally reflect contractual agreements made 30 to 45 days earlier.
Institutional Activities and Market Liquidity
Market liquidity is the ability to transact in financial markets quickly and at desired quantities without exerting an outsized effect on market prices.1 In March and April, even the deepest and most liquid financial markets experienced poor liquidity and extreme price volatility. Against this backdrop, we take a longer-range view and highlight a few trends in the activities of securities dealers, leveraged funds such as hedge funds and principal trading firms (PTFs), and mutual funds and ETFs that could have implications for market liquidity.
Channels of liquidity provision
This analysis focuses on the following three ways in which market liquidity is supported by institutions:
- direct liquidity provision through market making—that is, cases in which a firm buys and sells securities from market participants at posted bid and ask prices for which the market maker is compensated through the difference between the buying and selling prices, or the bid-ask spread
- funding liquidity provision through secured credit—that is, cases in which one firm provides secured credit that allows other financial institutions to undertake business models that directly or indirectly provide market liquidity
- indirect liquidity provision through arbitrage and trading—that is, cases in which firms' business models require them to buy and sell securities on a regular basis for purposes other than making markets that nonetheless create buying and selling opportunities for other investors
The flow chart in figure A depicts these three distinct channels of liquidity provision. Securities dealers—or, simply, dealers—are institutions that market, underwrite, and transact in a range of securities, including government debt, corporate bonds, and MBS. Many large dealers are subsidiaries of bank holding companies. As market makers, dealers are direct liquidity providers in the sense that they typically stand ready to buy and sell securities from their own holdings and are effectively compensated for providing market liquidity through the difference between the prices at which they buy and sell a particular security. Dealers also provide funding liquidity by offering secured credit to leveraged funds (shown by the line connecting the two types of institutions). In turn, although not market makers per se, leveraged funds regularly buy and sell securities at scale, often to take advantage of arbitrage opportunities. By doing so, leveraged funds provide selling and buying opportunities to other investors, bolstering market liquidity indirectly. The bottom row describes indirect liquidity provision by other asset managers such as mutual funds and ETFs. Like leveraged funds, these institutions buy and sell securities frequently and so can have material effects on liquidity. Unlike leveraged funds, some of these asset managers, such as MMFs, also provide funding liquidity to dealers in the repo market.2
Dealers' market making and liquidity provision
Dealer market making activities have evolved significantly since the 2007–09 crisis, with dealer inventory holdings of Treasury securities having increased since the crisis and inventories of corporate securities having decreased (figure B). While dealers generally continue to stand ready to buy and sell securities from their own holdings in the Treasury market, they no longer do so at scale in the corporate bond market and some other securities markets. Increasingly, dealers attempt to match clients who want to buy and sell particular securities in those markets.
Dealers intermediate in the Treasury market by buying and selling securities from clients while funding their inventory holdings in short-term secured funding markets. Dealer intermediation in the Treasury market received considerable attention during the intense market volatility in March. As investors sold less-liquid Treasury securities to obtain cash, dealers absorbed large amounts of these Treasury securities onto their balance sheets. It is possible that some dealers reached their capacity to absorb these sales, leading to a deterioration in Treasury market functioning. Actions taken by the Federal Reserve—including expanded repo operations, temporary regulatory relief, and expanded purchases of Treasury securities—were designed to alleviate the constraints on dealers and to improve Treasury market functioning (see the box "The Federal Reserve's Monetary Policy Actions and Facilities to Support the Economy since the COVID-19 Outbreak"). In the wake of these actions, dislocations in the Treasury market have subsided, and measures of market functioning, such as market depth and bid-ask spreads, have improved (figure C).
Although there is little indication that changes in corporate bond market intermediation by dealers have had a noticeable effect on market liquidity in normal times, there is evidence suggesting liquidity has become somewhat more fragile—that is, more likely to disappear—in times of stress.3 Specifically, during periods of market strain, corporate bond liquidity tends to decline, and the cost of transacting tends to rise substantially. Although this trend suggests that dealers may be less willing to engage in market making in the corporate bond market during times of stress, other changes in market structure, such as the increased prevalence of electronic trading, may also affect market liquidity.4 Against this backdrop, measures of corporate bond market liquidity deteriorated sharply in March 2020, although they have subsequently improved.
Besides market making, dealers also contribute to market liquidity by providing credit to leveraged funds such as hedge funds and other firms that engage in significant trading activity, including those that engage in high-frequency trading (HFT). This funding liquidity is provided in several ways, including repos.5 Leveraged funds, in turn, depend on the credit provided by dealers to finance their trading activities in a number of markets, including bond and equity markets.
Implications of leveraged funds' indirect liquidity provision
Leveraged funds, such as hedge funds, buy and sell securities frequently to exploit arbitrage opportunities and thereby are indirect providers of market liquidity. At the same time, most leveraged funds require a minimum level of preexisting market liquidity in order to execute their trading strategies, and leveraged funds that are not actively trading in a market because of poor liquidity may be required to deleverage by selling assets into the same market. This combination can lead to a rapid unraveling of market liquidity under certain circumstances. Seen in this light, a few hedge fund industry trends have important implications for understanding recent strains in market liquidity.
First, the concentration of hedge fund leverage has increased markedly. The top 25 hedge funds accounted for 50 percent of the industry's borrowing as of 2019:Q2, although they accounted for less than 14 percent of its net assets.6 The increase in leverage concentration has occurred over the past several years as dealers have reportedly given preferential terms to their most-favored hedge fund clients. Market participants have raised concerns over this concentration because distress at a few large hedge funds with disproportionately high leverage can have outsized effects, as they may have to sell large amounts of assets to meet margin calls or reduce portfolio risk during periods of market stress. Such deleveraging may have contributed to the poor liquidity conditions in financial markets in March.
Second, many hedge funds have increasingly relied on model-driven trading strategies, which has increased the potential for "crowding" in trading strategies. For example, the growing popularity of certain momentum- and volatility-sensitive strategies implies that many hedge funds may need to buy and sell the same types of securities at the same time. Common types of these strategies include those of "risk parity" and "commodity trading advisors" funds. Such strategies typically require selling when equity prices fall, which can amplify market moves in stress events.
A subset of leveraged firms that can be particularly problematic during stressful periods consists of PTFs.7 In normal times, PTFs provide a large amount of liquidity for different markets, particularly those that operate on electronic trading platforms. PTFs use proprietary, automated HFT strategies, particularly in equities, Treasury securities, and FX. Their high-frequency automated trading on electronic trading platforms is characterized by very short-term investment horizons. Some PTFs also arbitrage prices across market segments (for example, cash, futures, and options) and across markets (particularly among equities, Treasury securities, and FX). During periods of extreme market stress, some PTFs may abruptly reduce their trading, which can contribute to poor market liquidity and transmit stress quickly from one market to another.
Other asset managers' effects on market liquidity
In addition to dealers and leveraged funds, other asset managers can also have material effects on market liquidity. Some mutual funds offer daily redemptions to investors but invest in less-liquid assets, such as high-yield bonds and bank loans. These types of mutual funds have grown rapidly over the past decade or so. This pronounced form of liquidity transformation can make these funds particularly vulnerable to large redemptions during stressed conditions.8 If investors believe redemptions would negatively affect the ability of funds to meet future redemptions, they may have an incentive to redeem ahead of others. Such self-reinforcing dynamics could lead to waves of redemptions at the funds in market downturns, which may force funds to sell less-liquid assets at fire sale prices and result in further strains on market liquidity. Both high-yield funds and bank loan funds experienced heightened outflows in March, reaching 4 percent and 14 percent of assets under management, respectively.
One notable trend in the asset management industry over the past couple of decades is the shift from actively managed assets to passively managed mutual funds and ETFs. As investors in passive mutual funds tend to be less responsive to performance than those in active funds, this shift to passive investing might help reduce large redemptions arising from poor performance and, therefore, damp fire sale risks.9
At the same time, some types of exchange-traded products (ETPs)—leveraged and inverse ETPs—have features that could cause strains in market liquidity.10 Those two types of ETPs must rebalance their portfolios near the end of the day in order to meet fund objectives. By construction, the rebalancing is in the same direction as market movements earlier in the day. Because this pattern is well known by other market participants, there is the potential for "front running," or executing trades in anticipation of the rebalancing, leading to further liquidity strains.
1. For a detailed discussion of market liquidity, see Board of Governors of the Federal Reserve System (2019), Financial Stability Report (Washington: Board of Governors, November), https://www.federalreserve.gov/publications/files/financial-stability-report-20191115.pdf. Return to text
2. Dealers may also procure funding from banks and other dealers, while leveraged funds may source funding directly from MMFs through sponsored repos. Return to text
3. For additional information, see the discussion of liquidity fragility in Board of Governors of the Federal Reserve System (2019), Financial Stability Report (Washington: Board of Governors, November), pp. 14–16, https://www.federalreserve.gov/publications/files/financial-stability-report-20191115.pdf. Return to text
4. See Jack Bao, Maureen O'Hara, and Xing (Alex) Zhou (2018), "The Volcker Rule and Corporate Bond Market Making in Times of Stress," Journal of Financial Economics, vol. 130 (October), pp. 95–113; Hendrik Bessembinder, Stacey Jacobsen, William Maxwell, and Kumar Venkataraman (2018), "Capital Commitment and Illiquidity in Corporate Bonds," Journal of Finance, vol. 73 (August), pp.1615–61; Jens Dick-Nielsen and Marco Rossi (2019), "The Cost of Immediacy for Corporate Bonds," Review of Financial Studies, vol. 32 (January) pp. 1–41. Return to text
5. Other ways to provide credit include margin loans under prime brokerage agreements and derivatives. Return to text
6. See Securities and Exchange Commission Form PF, "Reporting Form for Investment Advisers to Private Funds and Certain Commodity Pool Operators and Commodity Trading Advisors," https://www.sec.gov/files/formpf.pdf. Return to text
7. 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: 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 text
8. There is some evidence that the largest bank loan mutual funds have increased their shares of holdings of most illiquid assets in recent years. Moreover, bank loans typically have lengthy settlement periods (usually longer than seven days), which could further constrain the funds' ability to convert loans into cash to meet large redemptions. See Kenechukwu Anadu and Fang Cai (2019), "Liquidity Transformation Risks in U.S. Bank Loan and High-Yield Mutual Funds," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, August 9), https://www.federalreserve.gov/econres/notes/feds-notes/liquidity-transformation-risks-in-US-bank-loan-and-high-yield-mutual-funds-20190809.htm. Return to text
9. See Kenechukwu Anadu, Mathias Kruttli, Patrick McCabe, Emilio Osambela, and Chae Hee Shin (2018), "The Shift from Active to Passive Investing: Potential Risks to Financial Stability?" Finance and Economics Discussion Series 2018-060 (Washington: Board of Governors of the Federal Reserve System, August), https://dx.doi.org/10.17016/FEDS.2018.060. Return to text
10. Leveraged ETPs attempt to offer multiples of a daily index return, while their inverse counterparts attempt to deliver multiples of daily inverse returns of an index. Both must rebalance their portfolios towards the end of the trading session to maintain their target exposures relative to their assets. Return to textReturn to text
3. 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
4. As market makers, dealers absorbed large amounts of less-liquid off-the-run Treasury securities from investors who sought to secure liquidity by selling assets or had to unwind positions, which reportedly expanded dealers' balance sheets against the constraints imposed by regulatory or risk-management considerations. Return to text
5. In addition to its increased asset purchases and funding facilities, the Federal Reserve announced a temporary change to its supplementary leverage ratio rule to ease strains in the Treasury market. The change excludes U.S. Treasury securities and deposits at Federal Reserve Banks from the calculation of the supplementary leverage ratio rule for holding companies until March 31, 2021. See Board of Governors of the Federal Reserve System (2020), "Federal Reserve Board Announces Temporary Change to Its Supplementary Leverage Ratio Rule to Ease Strains on the Treasury Market Resulting from the Coronavirus and Increase Banking Organizations' Ability to Provide Credit to Households and Businesses," press release, April 1, https://www.federalreserve.gov/newsevents/pressreleases/bcreg20200401a.htm. Return to text
6. Market depth indicates the quantity of an asset available to buy or sell at the best posted bid and ask prices. Return to text
7. 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
8. An oil supply dispute between Saudi Arabia and Russia also contributed to widening spreads for energy companies. Return to text
9. 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
10. Large price movements and poor liquidity conditions also posed serious challenges for some firms trading on a strategy that is based on an assumption that the differences in the implied volatilities across various derivatives should converge to zero. Return to text