1. Asset Valuations
A deteriorating economic outlook and higher interest rates lowered corporate valuations, while real estate valuations remained elevated
Since the May 2022 Financial Stability Report, the economic outlook deteriorated amid growing downside risks and heightened uncertainty. Central banks around the world tightened monetary policy in response to persistently high inflation. Against this backdrop, yields on long-term Treasury securities rose notably, which, along with diminished risk appetite, contributed to a decline in broad equity indexes and a widening of corporate credit spreads. The valuation measures tracked for most corporate financial assets are now near or below their historical averages.
In contrast, valuation pressures in real estate remained high. National average house prices continued to rise year over year, although recent data show a significant slowdown in growth and falling prices in some geographic locations. With valuations at high levels, house prices could be particularly sensitive to shocks. CRE prices continued to increase since the previous report, albeit at a slower pace in recent months. With both capitalization rates and capitalization spreads—the difference between capitalization rates and real Treasury yields—at low levels, CRE valuation pressures moved higher from already stretched levels. Farmland prices were also elevated relative to rents, driven by rising crop prices and limited inventories of land.
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||53,004||16.8||6.3|
|Commercial real estate||23,465||8.7||6.9|
|Investment-grade corporate bonds||6,973||3.9||8.1|
|High-yield and unrated corporate bonds||1,773||2.8||6.8|
|Price growth (real)|
|Commercial real estate**||3.9||2.9|
|Residential real estate***||4.8||2.7|
Note: The data extend through 2022: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 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 to 2022:Q2, as this market was fairly small before then.
** One-year growth of commercial real estate prices is from August 2021 to August 2022, and average annual growth is from 1998:Q4 to 2022:Q2. 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 August 2021 to August 2022, and average annual growth is from 1997:Q4 to 2022:Q2. Nominal prices are deflated using the CPI.
Source: For leveraged loans, PitchBook Data, 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, 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."
Treasury yields increased amid high volatility
Reflecting a tighter monetary policy stance associated with a very tight labor market and inflation far above the Federal Open Market Committee's 2 percent inflation objective, yields on Treasury securities further increased since the May report to near or above their median levels over the past quarter-century (figure 1.1). In contrast, a model estimate of nominal Treasury term premiums—a measure of the compensation investors require to hold longer-term Treasury securities rather than shorter-term ones—was little changed and low relative to its long-run history (figure 1.2).2 Consistent with heightened uncertainty about the economic outlook, a forward-looking measure of interest rate volatility derived from options prices increased from previously elevated levels (figure 1.3). Liquidity metrics, such as market depth, suggest that Treasury market liquidity has remained below historical norms (figure 1.4).3 Market liquidity strains could amplify price shocks and increase costs for investors when they adjust their holdings. Moreover, persistent liquidity strains could result in higher liquidity premiums and, as a result, lower valuations. For more information on market liquidity developments, see the box "Liquidity Conditions in Treasury and Other Core Financial Markets."
Box 1.1. Liquidity Conditions in Treasury and Other Core Financial Markets
Market liquidity—the ease of buying and selling an asset—is a key indicator of how well markets are functioning. Low liquidity can amplify the volatility of asset prices and result in larger price moves in response to shocks. In extreme cases, low liquidity can threaten market functioning, leading to a situation in which participants are unable to trade without incurring a significant cost. Liquidity conditions in the markets for Treasury securities are particularly important due to the key role those securities play in the financial system. This discussion updates the assessment of liquidity conditions in Treasury and other core financial markets from the May report. The Treasury market has continued to function smoothly over the period from the May report, but measures of trading costs have remained moderately elevated and liquidity appears to be less resilient than is typical. These liquidity strains appear to be primarily a consequence of the elevated interest rate volatility associated with uncertainty about the economic outlook. While measures of trading costs such as bid-ask spreads are only moderately elevated, the fact that intermediaries are posting historically low volumes of quotes may mean that the risk of a sharp further increase in trading costs could be higher than usual. Liquidity conditions in various other major markets remain moderately strained. Looking ahead, the Inter-Agency Working Group on Treasury Market Surveillance is expected to provide an update on its progress toward enhancing the resilience of the U.S. Treasury market.1 These enhancements include proposals intended to improve data quality and public transparency and enhance the resilience of market intermediation and market oversight.
Measuring liquidity depends on how trading takes place
The most liquid component of the Treasury market is the interdealer broker market in on-the-run Treasury securities, where trading takes place predominantly on platforms employing central limit order books (CLOBs).2 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. In contrast, dealer-to-client trading in off-the-run securities largely takes place using the "request for quote" (RFQ) protocol, whereby clients of Treasury securities dealers can obtain quotes for buying or selling a certain amount. Measures that capture different dimensions of liquidity include market depth, which is relevant only for CLOB-based markets, and the bid-ask spread, which can be observed for both CLOB- and RFQ-based markets. Market depth at the top of the book is the average of quantities available to buy or sell at the best quoted prices; greater market depth indicates a greater ability to instantaneously trade larger amounts without moving the price and, hence, a more liquid market.3 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.4
Liquidity remained low in the U.S. Treasury market
Figure A shows average top-of-book market depth for 2- and 10-year on-the-run Treasury securities. Between about October 2021 and the end of April 2022, market depth fell notably, which primarily reflected growing caution on the part of liquidity providers about posting quotes in large volumes in the face of heightened price volatility. That heightened volatility in turn reflected substantial uncertainty about the economic outlook and the appropriate monetary policy response. The reduction in market depth for shorter-maturity securities was relatively large—to levels around the low point seen during the onset of the COVID-19 pandemic—because the prices of those securities are more sensitive to news about the near-term economic outlook. Since the May report, market depth has remained low, reflecting the continued uncertainty about the economic outlook.
Figure B shows average bid-ask spreads. Spreads rose between October 2021 and mid-March 2022 and remain moderately wide. While spreads are moderately wider than was typical during the years before the pandemic, the fact that they have remained well below the pandemic-related peak in March 2020 contrasts with market depth remaining close to its pandemic-related troughs, particularly for shorter-maturity securities. This pattern of exceptionally low market depth but only moderately high spreads suggests that liquidity providers have continued to replenish the limited volume of quotes on the CLOB sufficiently rapidly in response to incoming order flow to prevent outsized moves in the best quoted prices over short periods. At the same time, the average size of trades (not shown) trended downward in the first quarter of 2022 and remained stable since the May report, suggesting that market participants have adapted to low market depth by splitting trades into smaller chunks to minimize the effect on prices. That said, splitting trades into smaller chunks may entail increased trading costs for some market participants—for example, because it may lengthen the time taken to execute trades. Moreover, the continued low level of market depth means that liquidity remains more sensitive to the actions of liquidity providers that use high-frequency trading strategies to replenish the order book rapidly. Greater concentration of liquidity provision among firms that may follow similar strategies can be a source of fragility, making it more likely that liquidity could further deteriorate sharply in response to future shocks.
The likely predominant driver of recent low liquidity appears to be elevated uncertainty about the economic situation and the outlook for monetary policy. In general, volatility and liquidity tend to move in opposite directions because higher volatility increases the riskiness of providing liquidity, and intermediaries therefore tend to either reduce the amount they quote as a way of managing the risk or charge more compensation for the risk of providing liquidity, in the form of a wider bid-ask spread. Current levels of liquidity appear broadly in line with the historical relationship between liquidity and volatility. This situation is in contrast to that at the height of the COVID-19 pandemic crisis, when liquidity deteriorated by more than the historical relationship with volatility would suggest, as intermediaries became less willing to provide liquidity in response to heavy selling pressures, as discussed in the November 2020 report.
Liquidity conditions in other parts of the Treasury market generally have also remained low in recent months, albeit to varying degrees. Treasury futures liquidity is low relative to its typical levels; however, it has been less strained than in the cash market over the past year. In contrast, for the off-the-run nominal securities and Treasury Inflation-Protected Securities, liquidity strains are more acute.5 That said, market participants are not reporting major problems obtaining quotes or executing trades.
Liquidity in other financial markets has also remained low
Liquidity conditions in some other crucial financial markets have remained strained since the May report. Figure C shows bid-ask spreads in the S&P 500 equity index, the West Texas Intermediate crude oil, and wheat futures markets. While equity futures' bid-ask spreads have narrowed since the May report, they remain elevated compared with historical levels.6 Bid-ask spreads in the oil futures market briefly widened significantly following Russia's invasion of Ukraine, to levels substantially higher than observed during the pandemic-related strains, but subsequently narrowed and have remained relatively stable since the May report. In contrast, bid-ask spreads in the wheat futures market have continued to narrow since the May report. Similar to the market for on-the-run Treasury securities, market depth in all of these other markets remains historically low, suggesting that in these markets, too, liquidity providers have replenished limited volumes of quotes sufficiently rapidly to prevent outsized moves in the best quoted prices over short periods. Nonetheless, these conditions suggest a higher-than-normal risk that bid-ask spreads may widen in the face of further shocks, making prices even more volatile. Also broadly similar to the Treasury market, bid-ask spreads in the corporate bond market widened slightly since the May report but remain well below their peaks at the onset of the pandemic.
1. The Inter-Agency Working Group on Treasury Market Surveillance is composed of staff from the U.S. Department of the Treasury, the Board of Governors of the Federal Reserve System, the Federal Reserve Bank of New York, the U.S. Securities and Exchange Commission, and the U.S. Commodity Futures Trading Commission. Return to text
2. On-the-run Treasury securities are the most recently auctioned securities of a given maturity, while off-the-run securities are those that were auctioned earlier. Return to text
3. In practice, market depth is an imperfect measure of the ability to trade without moving the price, because quotes can be both rapidly canceled or rapidly replenished in response to incoming order flow. Return to text
4. In liquid CLOB-based markets, the bid-ask spread is often close to or at the minimum tick size, the smallest allowed difference between bid and ask prices, and widens only for short periods during the day in response to incoming orders. However, average bid-ask spreads over the course of a day may still be informative about the variation in liquidity conditions over time. Return to text
5. The hierarchy of liquidity conditions being least strained in the futures market and most strained in the off-the-run cash market is consistent with typical patterns; for example, as discussed by Dobrev and Meldrum (2020), the futures Treasury market was notably more liquid than the cash market during the height of the COVID-19 pandemic crisis. See 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://www.federalreserve.gov/econres/notes/feds-notes/what-do-quoted-spreads-tell-us-about-machine-trading-market-stress-march-2020-20200925.html. Return to text
6. The bid-ask spreads for the E-mini S&P 500 futures are currently around the 75th percentile of their distribution since 2018. Return to text
Corporate debt market valuations fell just below historical medians
Since the May report, corporate bond yields increased more than those on comparable-maturity Treasury securities (figure 1.5). Consequently, corresponding corporate-to-Treasury spreads widened to somewhat above their historical medians, easing valuation pressures (figure 1.6). The excess bond premium, a measure that captures the gap between corporate bond spreads and expected credit losses, was slightly above its historical median, indicating moderate risk appetite (figure 1.7). Reflecting higher interest rates and elevated market volatility, corporate bond issuance declined in recent months.
Risk appetite in the leveraged loan market declined to low levels since the May report. Demand from both retail and institutional investors fell amid concerns that higher interest rates will weigh on profitability and credit quality. Spreads on leveraged loans in the secondary market widened and stood well above their respective averages since the 2007–09 financial crisis (figure 1.8). Furthermore, amid market volatility and fewer refinancing opportunities, leveraged loan issuance slowed considerably in the third quarter to its lowest quarterly level since 2009.
Equity market valuation pressures declined to near historical medians
Broad equity prices declined amid continued volatility over the period since the May report. Prices relative to earnings forecasts fell from previously elevated levels to be modestly above median levels, suggesting that valuations were moderate (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 a bit to its historical median (figure 1.10). Reflecting the considerable uncertainty in the markets, option-implied volatility continued to be elevated (figure 1.11). At the same time, the pace of initial public offerings was low compared with historical standards, following the exceptionally high issuance in 2021 and due to the recent volatility in prices.
Commercial real estate valuations remained high
Since the May report, valuation pressures for commercial properties increased further from already considerable levels. Aggregate CRE price indexes moved to record-high levels, although price increases have slowed sharply, partially in response to higher borrowing costs. Furthermore, some inflation-adjusted price measures began showing declines (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 (figure 1.13). Moreover, the spreads of capitalization rates to real Treasury yields—which provide a measure of risk appetite in this market—remained at the bottom third of their historical distributions through August. Although the levels of valuations across property types all remained high, some differences in valuations across segments of the CRE market reflected comparably weaker fundamentals. 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 for other property types. Meanwhile, in the July Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), banks reported weaker demand for most CRE loan categories and tighter lending standards for the second quarter of 2022 (figure 1.14).4
Farmland valuations increased further from already high levels
Farmland prices continued to increase since the May report and remained at high levels (figure 1.15). The ratios of farmland prices to rents increased to new historical highs (figure 1.16). Farmland valuations were supported by high and rising commodity prices, 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. Moreover, the inventory of farmland was limited.
House prices have decelerated sharply, but valuations remained high
Year-over-year house price increases have slowed significantly, with some measures pointing to outright declines in recent months, likely owing in part to rising borrowing costs (figure 1.17). Nationwide, house price-to-rent ratios leveled off but still stood above their mid-2000s peak even as prices in some locations began falling. A model of house price valuation based on prices relative to owners' equivalent rent and interest rates points to stretched valuations (figure 1.18). However, a measure of house valuations that incorporates market-based measures of rents (based on the rent for a new lease by a new tenant) is somewhat less elevated. As house price increases slowed across regions and property types, price-to-rent ratios also flattened out across regional markets (figure 1.19).
2. 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
3. Market depth reflects the quantity of an asset available to buy or sell at the posted bid and ask prices. Return to text