Board of Governors of the Federal Reserve System

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

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

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").

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.

 

References

 

 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