Board of Governors of the Federal Reserve System

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

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.

 

References

 

 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