1. Asset Valuations
Increased uncertainty about the economic outlook led to large fluctuations in asset prices
Since the November 2021 Financial Stability Report, amid news about the highly contagious Omicron variant, higher-than-expected inflation, and the Russian invasion of Ukraine, uncertainty about the economic outlook increased, and prices of financial assets fluctuated widely. The Russian invasion of Ukraine and the subsequent imposition of sanctions on Russia disrupted commodity markets, resulting in a significant rise in commodity prices (see the box "Commodity Market Stresses following Russia's Invasion of Ukraine"). On net, Treasury yields increased markedly, broad equity prices declined notably, and corporate bond spreads widened considerably. While the effect of recent developments on asset cash flows remained uncertain, valuation measures based on current expectations of cash flows continued to be high relative to historical norms.
House prices continued to rise at a rapid pace that further outstripped rent growth. With valuations at high levels, house prices could be particularly sensitive to shocks. Nonetheless, little evidence to date exists of an erosion in mortgage underwriting standards or a surge in speculative practices, suggesting that while a negative shock to house prices may hurt homeowners, such a shock is unlikely to be amplified by the financial system.
Driven by the multifamily and industrial sectors, overall commercial real estate (CRE) prices continued to increase since the November report, with some price indexes surpassing their 2006 peaks. With capitalization rates at low levels and capitalization spreads at moderate levels, CRE valuation pressures remained somewhat on the high side. Farmland prices were elevated relative to rents and incomes, although farm incomes are broadly expected to rise.
Table 1.1 shows the sizes of the asset markets discussed in this section. The largest asset markets are those for equities, residential real estate, CRE, and Treasury securities.
Table 1.1. Size of selected asset markets
(billions of dollars)
|Average annual growth,
|Residential real estate||48,825||16.5||6.1|
|Commercial real estate||23,787||12.7||7.2|
|Investment-grade corporate bonds||6,738||3.3||8.2|
|High-yield and unrated corporate bonds||1,753||8.3||7.1|
|Leveraged loans *||1,341||12.4||14.3|
|Price growth (real)|
|Commercial real estate **||9.4||3.1|
|Residential real estate***||10.4||2.6|
Note: The data extend through 2021:Q4. Average annual 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 nominal market value; bonds and loans are at nominal 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:Q4 to 2021:Q4, as this market was fairly small before then.
** One-year growth of commercial real estate prices is from December 2020 to December 2021, and average annual growth is from 1998:Q4 to 2021:Q4. Both growth rates are calculated from value-weighted nominal prices deflated using the consumer price index (CPI).
*** One-year growth of residential real estate prices is from December 2020 to December 2021, and average annual growth is from 1997:Q4 to 2021:Q4. Nominal prices are deflated using the CPI.
Source: For leveraged loans, S&P Global, Leveraged Commentary & Data; for corporate bonds, Mergent, Fixed Income Securities Database; for farmland, Department of Agriculture; for residential real estate price growth, CoreLogic, Inc.; 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."
Amid high volatility, Treasury yields rose from very low levels to somewhat above their pre-pandemic levels
Reflecting a less accommodative monetary policy stance associated with elevated inflation and a tight labor market, yields on Treasury securities increased markedly and reached somewhat above their pre-pandemic levels (figure 1.1). Model estimates of Treasury term premiums also increased notably but remained moderate by historical standards (figure 1.2).3 Further increases in Treasury yields, especially if accompanied by a weaker economic outlook, could put downward pressure on valuations in various other markets. Consistent with heightened uncertainty about the economic outlook, a forward-looking measure of Treasury market volatility derived from options prices increased significantly and remained elevated (figure 1.3). Since the November report, liquidity metrics, such as market depth, suggest a notable deterioration in Treasury market liquidity (figure 1.4).4 In addition, the price spread of the most recently issued Treasury securities over previously issued comparable-maturity Treasury securities widened, reflecting a willingness to pay a higher premium for holding actively traded liquid securities. Low market liquidity likely contributed to large fluctuations in prices of financial assets, but markets functioned well overall. For more information on market liquidity developments, see the box "Recent Liquidity Strains across U.S. Treasury, Equity Index Futures, and Oil Futures Markets." Of note, last November, the Inter-Agency Working Group for Treasury Market Surveillance released a report analyzing the disruptions to the U.S. Treasury markets at the onset of the COVID-19 pandemic in March 2020 and discussing potential reforms.5
Box 1.1. Recent Liquidity Strains across U.S. Treasury, Equity Index Futures, and Oil Futures Markets
Market liquidity—the ease of buying and selling desired quantities of an asset—is an important indicator of how well markets are functioning. According to some measures, market liquidity has declined since late 2021 in the markets for recently issued U.S. cash Treasury securities and for equity index futures. These markets play important roles in the functioning of the economy and financial system and are usually highly liquid. Low liquidity in these markets can amplify price volatility and result in unexpected tightening in financial conditions. In extreme cases, such as the market turmoil at the onset of the pandemic in March 2020, low liquidity can impair the ability of the financial system to respond to a large shock because investors may not be able to adjust their holdings of assets to raise cash or hedge risks, or they may be able to do so only at a substantial cost. While the recent deterioration in liquidity has not been as extreme as in some past episodes, the risk of a sudden significant deterioration appears higher than normal. In addition, since the Russian invasion of Ukraine, liquidity has been somewhat strained at times in oil futures markets, while markets for some other affected commodities have been subject to notable dysfunction, as discussed in the box "Commodity Market Stresses following Russia's Invasion of Ukraine."
Different measures capture different dimensions of market liquidity
Trading in the financial markets considered here takes place on electronic central limit order books (CLOBs). On a CLOB, market participants can either provide liquidity by posting quotes to buy and sell securities or consume liquidity by submitting an order to buy or sell at the best available quoted price. Measures that capture different dimensions of market liquidity in CLOB markets include the bid-ask spread and quoted depth. The bid-ask spread is the difference between the best "bid" quote to buy an asset and the best "ask" quote to sell that asset. Smaller bid-ask spreads indicate lower trading costs and, hence, more liquid markets. Quoted depth is the quantity of an asset available to buy or sell at the best quoted prices. Greater depth indicates the ability to trade larger amounts without accepting a worse price and, hence, more liquid markets.1
Liquidity providers bear the risk that the quotes they post become stale and are taken advantage of by faster traders if the prevailing price moves. This risk is of greater concern when prices become more volatile. In addition, the risk associated with holding inventories of securities also increases with higher volatility. Liquidity providers reduce these risks by quoting in lower quantities and possibly also widening bid-ask spreads. Thus, markets tend to be less liquid during periods of higher volatility. In extreme cases, some liquidity providers may pull back from the market altogether, which can result in very low depth and wider-than-usual bid-ask spreads.
Market depth has recently deteriorated across a range of markets
Quoted depth has decreased since late 2021 for the interdealer U.S. Treasury securities, S&P 500 E-mini futures, and West Texas Intermediate crude oil futures markets (figure A). Initially, in Treasury and equity markets, the decline in depth reflected rising uncertainty about the outlook for monetary policy; in the Treasury market, the decreases in depth were greatest for bonds with shorter maturities because the prices of those securities are more sensitive to expectations for monetary policy over the near term. In oil markets, depth has declined particularly sharply in recent months as a result of the elevated level of uncertainty and volatility associated with the Russian invasion of Ukraine.
Recently, depth in these markets has been lower than is typical even after taking into account the level of volatility, as shown for the oil market in figure B. This markedly low depth could indicate that liquidity providers are being particularly cautious, and liquidity may be more fragile than usual. Declining depth at times of rising uncertainty and volatility could result in a negative feedback loop, as lower liquidity in turn may cause prices to be more volatile.
Bid-ask spreads remain more stable in the most liquid markets
While depth has been low, quoted bid-ask spreads paint a more mixed picture (figure C). Average bid-ask spreads in the most liquid Treasury and equity markets have increased only slightly above their typical levels.2 These mild increases suggest that, though liquidity providers have been less willing to quote in large size, they have replenished quotes sufficiently quickly to meet incoming orders without exhausting all quotes at the best prices. Depleting the best quotes would have caused bid-ask spreads to widen until new quotes at narrower spreads were posted subsequently. Moreover, at least some market participants may have been able to split trades into smaller transaction sizes to avoid exhausting all the quotes available at the best prices.3
However, bid-ask spreads in some other markets increased more notably before partially falling back, as illustrated in figure C for oil futures. To shed more light on liquidity provision for oil futures, figure D shows the 10th and 90th percentiles of bid-ask spreads within each day, along with their average level, for the period since the beginning of the year. On days of larger variations in spreads (as captured by a widening of the gray area between the 10th and 90th percentiles), incoming orders more often exhausted all available quotes at the best prices, causing spreads to widen temporarily until new quotes at narrower spreads were posted. However, even on those days, there were times during the day when quoted spreads were fairly tight, and more trading took place at these times.4 These findings suggest that investors who are capable of timing their trades to when spreads are narrow are able to avoid large increases in trading costs. Furthermore, market commentary does not point to substantial difficulties in obtaining quotes in oil markets, and the increases in bid-ask spreads are less extreme when measured relative to prices.
It is difficult to predict periods of extreme market illiquidity
While recent low depth in the most liquid Treasury and equity markets has not generally been accompanied by extremely high and volatile bid-ask spreads, that situation could change if liquidity providers were to slow or stop replenishing quotes in response to incoming orders. However, as demonstrated in two recent episodes of low market depth in August 2019 and March 2020, it is difficult to predict whether market liquidity would deteriorate in this way. Figure E compares the evolution of quoted depth and bid-ask spreads for the 10-year Treasury note during these two episodes. The left panel shows that quoted depth decreased rapidly from late February to early March 2020. Bid-ask spreads stayed low and stable until early March but then increased dramatically in mid-March after some liquidity providers scaled down their market-making activity. In contrast, the right panel shows an episode in August 2019 when a prolonged period of low depth was not followed by heightened bid-ask spreads.5
In conclusion, quoted depth is currently low in Treasury, equity, and oil markets, but there have been no reports of severe market functioning problems, and the effect on trading costs for many investors has likely been limited. Thus, the current state of liquidity in these key markets does not appear to be a substantial barrier to efficient capital allocation and risk management within the economy. However, the low level of depth means that liquidity provision remains fragile due to heavier reliance on sufficiently rapid quote replenishment to meet trading demands without resulting in sharp price moves. This dependence on higher-velocity quote replenishment when depth is low could pose an important vulnerability in these markets, as it suggests that there is a higher-than-normal risk that a significant deterioration in liquidity provision could make prices even more volatile and lead to market dysfunction.6
1. For a description of other measures of market liquidity, see, among others, the box "What Has Been Happening to the Liquidity of U.S. Treasury and Equity Futures Markets?" 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; and Abdourahmane Sarr and Tonny Lybek (2002), "Measuring Liquidity in Financial Markets," IMF Working Paper 02/232 (Washington: International Monetary Fund, December), https://www.imf.org/en/Publications/WP/Issues/2016/12/30/Measuring-Liquidity-in-Financial-Markets-16211. Return to text
2. Average bid-ask spreads in most of these markets, except for the longest-tenor Treasury securities, are usually only slightly higher than a single "tick," the smallest permitted difference between quoted prices. The tick size for the 2-year Treasury note is 1/256 of a dollar per $100 of par value, while that for the 10-year Treasury note and the 30-year Treasury bond is 4/256 of a dollar per $100 of par value. The tick size for the S&P 500 E-mini futures contract is $0.25 per index point, and that for the West Texas Intermediate crude oil futures contract is $0.01 per barrel. Return to text
3. Electronic trading allows investors to minimize the cost of trading by splitting larger transactions into multiple smaller transaction amounts, allowing quoted depth to get replenished in between. For example, see Bank for International Settlements, Markets Committee (2020), FX Execution Algorithms and Market Functioning (Basel, Switzerland: BIS, October), https://www.bis.org/publ/mktc13.pdf; and Dhara Ranasinghe and Saikat Chatterjee (2020), "Pandemic Propels Old-School Bond Traders towards an Electronic Future," Reuters, June 22. Return to text
4. For comparison, in March 2020, the intraday variations in quoted bid-ask spreads for recently issued 30-year Treasury bonds were significantly larger—and spreads were reverting closer to their typical levels much less frequently—than observed during the current episode in the oil market, suggesting that the deterioration in liquidity provision was more severe during the March 2020 episode. Nonetheless, similar to the current episode, trading volumes were somewhat more concentrated at times when quoted spreads were narrower, as documented in Dobrislav Dobrev and Andrew Meldrum (2020), "What Do Quoted Spreads Tell Us about Machine Trading at Times of Market Stress? Evidence from Treasury and FX Markets during the COVID-19-Related Market Turmoil in March 2020," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, September 25), https://doi.org/10.17016/2380-7172.2748. Return to text
5. A more comprehensive comparison of Treasury market depth following different episodes of market stress can be found in Alex Aronovich, Dobrislav Dobrev, and Andrew Meldrum (2021). "The Treasury Market Flash Event of February 25, 2021," FEDS Notes (Washington: Board of Governors of the Federal Reserve System, May 14), https://doi.org/10.17016/2380-7172.2909. Return to text
6. An extreme case of slow quote replenishment could increase the risk of observing large directional price moves and reversals even on thin trading flows. Episodes such as the sterling flash event on October 7, 2016, further reveal the potential for extreme events of this kind to have some broader economic effects as noted by Bank for International Settlements, Markets Committee (2017), The Sterling ‘Flash Event' of 7 October 2016 (Basel, Switzerland: BIS, January), https://www.bis.org/publ/mktc09.pdf. Return to text
Corporate bond valuations eased somewhat but remained high
Heightened uncertainty weighed on risk appetite for corporate bonds, increasing their yields considerably more than those on comparable-maturity Treasury securities (figure 1.5).6 Consequently, corresponding corporate-to-Treasury spreads widened, easing valuation pressures somewhat. Even so, corporate bond spreads remained low by historical standards, suggesting that valuations continued to be high (figure 1.6).7 The excess bond premium, which is a measure that captures the gap between corporate bond spreads and expected credit losses, also suggests that investor risk appetite was high. In March, the premium stood at the bottom decile of its historical distribution (figure 1.7).8
Reflecting higher interest rates and heightened uncertainty, corporate bond issuance declined in recent months but generally stayed solid. Meanwhile, the share of new speculative-grade bonds with the lowest ratings was at low levels by historical standards. In contrast, the share of outstanding bonds with the lowest investment-grade ratings—the so-called triple-B cliff—reached its highest level in two decades, suggesting that many investment-grade bonds remain vulnerable to being downgraded to speculative-grade in the event of a negative economic shock.
Risk appetite in the leveraged loan market appeared to have changed little and continued to be somewhat elevated. Spreads on lower-rated leveraged loans in the secondary market were little changed and stood at the lower quintile of their historical distribution for the period since the 2008 financial crisis (figure 1.8). Despite a temporary slowdown due to the Russian invasion of Ukraine, leveraged loan issuance remained solid, on balance, as demand for floating-rate products stayed strong amid expectations for further rate increases and was supported by elevated risk appetite. Separately, leveraged loan market benchmark interest rates are transitioning smoothly from LIBOR to the Secured Overnight Financing Rate (SOFR) (see the box "LIBOR Transition Update").
Box 1.2. LIBOR Transition Update
There has been a clear shift away from the use of U.S. dollar (USD) LIBOR as a reference rate in financial contracts since the start of the year. This shift is consistent with supervisory guidance issued by the Federal Reserve and other U.S. and global regulators encouraging banks to stop most new use of USD LIBOR by the end of 2021.
The transition away from LIBOR is now largely complete in floating-rate note markets, where nearly all new issuance now references SOFR. In securitization markets, Fannie Mae and Freddie Mac stopped accepting LIBOR adjustable-rate mortgages in 2021, and all associated mortgage-backed securities (MBS) issuance is now tied to SOFR. Likewise, SOFR is now the dominant benchmark in interest rate swaps trading between dealers and in cross-currency basis swaps between USD and other major currencies (figure A).
The syndicated loan market, which had been slower to move away from LIBOR, shifted almost entirely to SOFR-referenced products in early 2022 (figure B). Data on bilateral (nonsyndicated) loans are less available, but supervisory assessments indicate that most banks have reduced LIBOR lending sharply since the start of the year, with most loans now referencing SOFR. There appears to be only limited lending activity based on credit-sensitive alternatives to SOFR. Hedging opportunities for those rates also appear to be limited; while futures markets and swaps clearing have developed on some credit-sensitive rates, activity has thus far remained negligible.
Despite this progress, there are still some specific areas in which USD LIBOR use has continued, most notably in exchange-traded futures and options markets, where supervised entities play a less significant role. While SOFR futures have grown noticeably over the past several months, LIBOR has still accounted for a substantial proportion of interest rate futures trading. Because futures markets play an important role in helping end users hedge their risks, which are now associated with SOFR, it will be important to see continued progress away from LIBOR over this year.
The start of the year marked the end of publication of two little-used USD LIBOR tenors (the one-week and two-month USD LIBOR rates) as well as all tenors of Swiss franc and euro LIBOR. Several tenors of sterling and yen LIBOR also ended, while some other tenors continued to be published as nonrepresentative "synthetic" rates that are now based on spread-adjusted risk-free rates rather than on polls of banks. The transition from all four of the non-USD LIBOR currencies went smoothly as a result of extensive preparations.
With most new use of USD LIBOR now at an end, attention has turned toward addressing the risks in legacy contracts. While the one-week and two-month USD LIBOR rates were little used, there are substantial legacy positions in the remaining overnight, one-month, three-month, six-month, and one-year USD LIBOR tenors, which will cease to be published as panel-based, representative rates after June 30, 2023. In March 2021, the Alternative Reference Rates Committee estimated outstanding legacy USD LIBOR exposures at roughly $223 trillion. Approximately $74 trillion of these legacy contracts are set to mature beyond the critical date of June 2023, and some of those contracts lack adequate fallback language.
In March, the Congress passed, and President Biden signed into law, new statutory provisions that address LIBOR contracts that do not have adequate fallback language. The legislation marked an important step in helping ensure that these legacy contracts can smoothly transition away from LIBOR. The law requires the Federal Reserve Board to issue rules to designate spread-adjusted, SOFR-based fallbacks for such contracts.Return to text
Broad equity prices were highly volatile and declined notably on net
Amid increasing interest rates and news on both the Omicron variant and the Russian invasion of Ukraine, broad equity prices fluctuated widely and declined notably, on net, since the November 2021 Financial Stability Report. While the effect of high inflation and the Russia–Ukraine conflict on corporate earnings remained uncertain, earnings forecasts of private-sector analysts were revised a bit higher. Consequently, prices relative to earnings forecasts declined somewhat from previously very elevated levels but were still in the top quintile of their historical distribution, suggesting that valuations eased slightly (figure 1.9). Meanwhile, the difference between the forward earnings-to-price ratio and the expected real yield on 10-year Treasury securities—a rough measure of the extra compensation that investors require for holding stocks relative to risk-free bonds, known as the equity premium—declined moderately (figure 1.10). Option-implied volatility increased significantly before reversing part of the run-up to still-elevated levels (figure 1.11). Consistent with the large price fluctuations and the uncertainty over the outlook for corporate profitability, the pace of initial public offerings declined and was low compared with historical standards.
Commercial real estate valuations remained somewhat on the high side
Since the November Financial Stability Report, aggregate CRE price indexes continued to increase, driven by the multifamily and industrial sectors (figure 1.12). Capitalization rates at the time of property purchase, which measure the annual income of commercial properties relative to their prices, continued to decline and were at historical lows in February (figure 1.13). However, the spreads of capitalization rates to real Treasury yields—which provide a measure of risk appetite in this market—were little changed through February, remaining near their historical averages. Valuations in some segments of the CRE markets reflected weaker fundamentals compared with other segments. For example, vacancy rates and increases in asking rents were weaker in the retail and office sectors, and capitalization rates for those property types remained higher than those for other property types. Meanwhile, in the January Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), banks reported stronger demand for CRE loans and easier lending standards for the last quarter of 2021, largely reflecting strengthening fundamentals (figure 1.14). Considering all these factors, CRE valuations appeared somewhat on the high side across property types.
Farmland prices relative to rents remained elevated
Farmland prices were at high levels, and the ratios of farmland prices to rents remained close to their historical highs (figures 1.15 and 1.16). Nevertheless, recent price increases in commodity markets suggest that the outlook for farm income was strong, on balance, as the positive effects of a substantial rise in prices of agricultural commodities, such as wheat and corn, appeared to outweigh the negative effects of higher prices for inputs, like fuel and fertilizers.
House prices continued to increase at a rapid pace, and price-to-rent ratios remained high relative to historical levels
House prices continued to increase at a rapid pace, which may reflect strong demand for housing space as people continued to spend more time at home, as well as constraints on supply (figure 1.17). Nationwide, house price-to-rent ratios increased further and stood slightly above the peak of the mid-2000s. A model of house price valuation also points to stretched valuations (figure 1.18). However, house valuations do not seem as stretched if valuation measures incorporate market-based measures of rents. For example, using the latest asking rents that tenants would pay when current leases expire and are renewed, house valuations appeared to be well below their peak of the mid-2000s. House price increases were widespread across regions and property types, and price-to-rent ratios also increased noticeably across regional markets (figure 1.19). Loan-to-value ratios and debt-to-income ratios were stable in recent years, suggesting that there is little evidence to date that recent house price increases were driven by a surge in speculative activity, an erosion in mortgage underwriting standards, or increased use of high-leverage loan products.
Hence, a negative shock to house prices may hurt homeowners, but such a shock is unlikely to be amplified by the financial system. Credit availability for borrowers with lower credit scores improved slowly but remained below pre-pandemic levels. After staying at extremely low levels for most of the pandemic period, the number of foreclosure starts rose following the expiration of federal foreclosure protections at the end of 2021, returning to roughly their pre-pandemic levels.
3. Treasury term premiums capture the difference between the yield that investors require for holding longer-term Treasury securities and the expected yield from rolling over shorter-dated ones. Return to text
4. Market depth indicates the quantity of an asset available to buy or sell at the best posted bid and ask prices. Return to text
5. For details on past disruptions to U.S. Treasury market functioning and potential market structure reforms that could help improve resilience, 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 (2021), Recent Disruptions and Potential Reforms in the U.S. Treasury Market: A Staff Progress Report (Washington: Inter-Agency Working Group for Treasury Market Surveillance, November), https://home.treasury.gov/system/files/136/IAWG-Treasury-Report.pdf. Return to text
6. For a detailed discussion on risk appetite, see the box "Vulnerabilities from Asset Valuations, Risk Appetite, and Low Interest Rates" in Board of Governors of the Federal Reserve System (2021), Financial Stability Report (Washington: Board of Governors, May), pp. 15–18, https://www.federalreserve.gov/publications/files/financial-stability-report-20210506.pdf. 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 include a liquidity risk premium. Return to text
8. 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