Board of Governors of the Federal Reserve System

1. Asset Valuations

Asset valuations increased to elevated levels relative to fundamentals

Since the October report, equity valuations increased further. Valuations in corporate bond markets also appeared stretched as corporate credit spreads, the difference in yields on corporate bond and yields on similar-maturity Treasury securities, narrowed since the previous report, falling to levels in the lower range of their historical distributions. Liquidity in short-term Treasury markets remained low by historical standards, although market liquidity was consistent with elevated measures of interest rate volatility. Nonetheless, Treasury market liquidity conditions could amplify the impact of shocks on asset valuations.

Residential real estate valuations remained near the peak levels seen in the mid-2000s. CRE market conditions continued to deteriorate, especially for the office sector, and prices continued to decline against a backdrop of high vacancy rates and weakening rents. Farmland prices were historically elevated relative to rents, reflecting 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, Treasury securities, and CRE.

Table 1.1. Size of selected asset markets

Treasury yields decreased slightly and remain high relative to the past 15 years

Yields on Treasury securities decreased slightly since the October report but remained close to their highest levels over the past decade and a half (figure 1.1). A model-based estimate of the nominal Treasury term premium—a measure of the compensation that investors require to hold longer-term Treasury securities rather than shorter-term ones—remained low relative to its long-run history despite edging up through March (figure 1.2). While interest rate volatility implied by options declined a touch, it remained elevated by historical norms (figure 1.3). This volatility reflected, in part, uncertainty about the economic outlook and the associated path of monetary policy, which likely heightened the sensitivity of Treasury yields to news about output growth, inflation, and the supply of Treasury securities.

Measures of equity market valuations rose further from already high levels

The ratio of prices to expected 12-month earnings, or the P/E ratio, increased since the October report and currently sits in the upper end of its historical distribution since 1989 (figure 1.4). The difference between the forward P/E ratio and the real 10-year Treasury yield—a measure of the additional return that investors require for holding stocks relative to risk-free bonds (the equity premium)—declined, on net, since the October report and currently stands well below its historical median (figure 1.5).² Equity market volatility was subdued, and option-implied volatility remained in the lower quarter of its historical distribution (figure 1.6).

Spreads in corporate debt markets narrowed to low levels

Yields for both investment- and speculative-grade bonds fell a bit since the October report and currently stand near the median of their respective historical distributions (figure 1.7). While the decline in corporate bond yields was modest, it nevertheless outpaced that of comparable-maturity Treasury securities, and, as a result, corporate bond spreads narrowed to levels that are low relative to their historical distributions (figure 1.8). The excess bond premium—a risk premium measure that captures the gap between corporate bond spreads and expected credit losses—remained near its historical mean (figure 1.9). Market-based forecasts of credit quality (one-year-ahead default probabilities) of nonfinancial firms have mildly improved since the October report but remain somewhat elevated by historical standards for speculative-grade issuers.

The average spread on leveraged loans in the secondary market fell a touch since the October report but remained roughly in line with its average over the past decade (figure 1.10). The trailing 12-month loan default rate moved up, on net, since the last report, and the year-ahead expected default rate remained somewhat elevated relative to its historical trend.

Market liquidity stayed near the lower end of its historical range

Market liquidity refers to the ease and cost of buying and selling an asset. 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.

Treasury market liquidity is important because of the key role these securities play in the financial system. Various measures of market liquidity, such as market depth, suggest that liquidity in the Treasury cash market remained low (figures 1.11 and 1.12), although at levels that reflect elevated measures of interest rate volatility. The effect of low levels of market depth on price impact has been limited because market participants split trades into smaller quantities, and liquidity providers have been able to replenish the limited volume of quotes rapidly enough to meet incoming order flow without large moves in prices. Nevertheless, conditions in the Treasury cash market appear challenged and could amplify shocks.

In other markets, liquidity conditions present a mixed picture. Liquidity in corporate bond markets remained in line with the average level observed in recent years, and bid-ask spreads were close to their lowest levels since the 2007–09 financial crisis. In contrast, liquidity conditions in equity markets remained low by longer-term historical standards and deteriorated somewhat despite lower equity volatility (figure 1.13).

Commercial real estate prices declined but remained high relative to rents

Aggregate CRE prices measured in inflation-adjusted terms continued to decline over the second half of last year (figure 1.14), with declines in these price measures broad based across all CRE sectors. These transaction-based price measures likely do not yet fully reflect the deterioration in CRE market prices because, rather than realizing losses, many owners wait for more favorable conditions to put their properties on the market. Capitalization rates at the time of property purchase, which measure the annual income of commercial properties relative to their prices, moved modestly higher but remained at historically low levels, suggesting that prices remain high relative to fundamentals (figure 1.15). The CRE office sector has faced strains resulting from an ongoing post-pandemic adjustment, and these strains could contribute to additional weakness in prices and rents going forward. Vacancy rates for offices located in central business districts and coastal cities increased further, and rents continued to decline since the October report. In the October 2023 and January 2024 Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), banks reported weaker demand and tighter standards for all CRE loan categories during the second half of 2023 (figure 1.16).

Residential real estate valuations remained high relative to rents as house prices continued to increase

Valuations in the residential real estate sector remained at elevated levels relative to historical standards and moved higher since the October report. House prices continued to rise through the first two months of the year (figure 1.17). A model of house price valuation based on prices relative to market rents and the real 10-year Treasury yield suggests that valuations in housing markets were increasingly stretched. Moreover, an alternative measure of valuation pressures (which uses owners' equivalent rent instead of market rents and, therefore, has a longer history) also suggested elevated valuations (figure 1.18). Moreover, the median price-to-rent ratio measured across a wide distribution of geographic areas remained close to its previous peak in the mid-2000s (figure 1.19). That said, credit conditions for borrowers remained tighter relative to the early 2000s, suggesting that weak credit standards are not driving house price growth.

Farmland valuations remained high relative to farm income

Farmland valuations remained elevated, as farmland prices increased to near-historical highs (figure 1.20). Farmland price-to-rent ratios diverged further from their historical norms, reaching a level more than twice the median of their historical distribution (figure 1.21). Prices continued to be sustained in the short run by limited farmland inventory despite declining farm income, elevated interest rates, and higher operating costs.

 

References

 2. This estimate is constructed based on expected corporate earnings for 12 months ahead. Alternative measures of the equity premium that incorporate longer-term earnings forecasts suggest more elevated equity valuation pressures. Return to text