Board of Governors of the Federal Reserve System

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

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.

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).

References

 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