Board of Governors of the Federal Reserve System

1. Asset Valuations

Asset valuation pressures rose to a notable level

Since the May 2023 report, valuations in equity markets increased modestly from an already high level even as yields on Treasury securities increased substantially. Corporate credit spreads edged down and were somewhat below their historical averages. Liquidity in Treasury markets remained challenged. While trading conditions largely recovered from the notable strains seen following Silicon Valley Bank's failure, they could again deteriorate in the face of further negative shocks.

Property prices remain elevated relative to fundamentals. In the market for residential real estate, house prices started increasing again in recent months and prices relative to rents remained near all-time highs. In the market for CRE, rental income relative to property prices remained low from a historical perspective, despite recent declines in property values. Fundamentals in the market for office properties were especially weak, as vacancy rates have risen and rent growth slowed. Farmland prices were historically elevated relative to rents, reflecting higher 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 residential real estate, equities, Treasury securities, and CRE.

Table 1.1. Size of selected asset markets

Treasury yields increased substantially and now stand at the highest levels in the past 15 years

Yields on Treasury securities moved notably higher since the May report and now stand 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—increased but remained low relative to its long-run history (figure 1.2). Interest rate volatility implied by options remained elevated by historical norms, reflecting, in part, uncertainty about the economic outlook and the path of monetary policy (figure 1.3).

Equity market valuation pressures remained notable

Valuations in equity markets increased modestly from an already high level since the May report. The pace of equity price increases exceeded that of expected earnings, and the forward price-to-earnings ratio rose to a level further above its historical median (figure 1.4).

The difference between the forward earnings-to-price 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 since the May report to levels well below historical norms (figure 1.5).² Equity market volatility continued to decline from the elevated levels reached earlier this year and currently stands slightly above its historical median (figure 1.6).

Spreads in corporate debt markets narrowed modestly

Yields on corporate bonds rose since the May report and remain above the median of their historical distributions, as yields on comparable-maturity Treasury securities also increased (figure 1.7). Corporate bond spreads, measured as the difference in yields between corporate bonds and comparable-maturity Treasury securities, narrowed modestly and currently stand a bit below their historical median (figure 1.8). However, 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). The trailing 12-month default rate for all corporate bonds edged up over the past year but stands well below its historical median. For speculative-grade corporate bonds in particular, the trailing 12-month default rate moved up more over the same time period and stands at about its historical median.

Valuations in leveraged loan markets were little changed from the previous report. The average spread on leveraged loans above their benchmark rates in the secondary market fell modestly and remained near its average over the past decade (figure 1.10). The trailing 12-month loan default rate increased further since the last report and stands well above its historical median since the Great Recession, but the year-ahead expected default rate declined moderately.

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 while Treasury market liquidity was largely in line with expectations given interest rate volatility, it remained below historical norms (figures 1.11 and 1.12). This low level of market depth could indicate that liquidity providers are being particularly cautious, and liquidity may be less resilient than usual.

In other markets, liquidity conditions were little changed since the previous report and present a more mixed picture. In corporate bond markets, bid-ask spreads remained well below pandemic levels, suggesting ample liquidity, while in equity markets, depth in the S&P 500 futures markets stayed at below-average levels (figure 1.13).

Commercial real estate valuations remained elevated, even as prices continued to decline

Aggregate CRE prices measured in inflation-adjusted terms continued declining through August (figure 1.14). Capitalization rates at the time of property purchase, which measure the annual income of commercial properties relative to their prices, have increased modestly from recent historically low levels but have not increased as much as real Treasury yields, suggesting that prices remain high relative to rental income (figure 1.15). CRE valuations are particularly elevated for the office sector, where fundamentals are especially weak for offices in central business districts, with vacancy rates increasing further and rent growth declining since the May report. In the April and July 2023 Senior Loan Officer Opinion Survey (SLOOS), banks reported weaker demand and tighter standards for all CRE loan categories over the first half of 2023 (figure 1.16).

House prices started increasing again in recent months, and valuations remained high

Since the last report, valuations in residential real estate markets increased from already elevated levels. House prices, after holding steady earlier this year, started rising again in recent months (figure 1.17). A model of house price valuation based on prices relative to owners' equivalent rent and the real 10-year Treasury yield suggests that valuations in housing markets were increasingly stretched (figure 1.18). Moreover, the median price-to-rent ratio measured across a wide distribution of geographical areas remained close to its previous peak in the mid-2000s (figure 1.19). That said, credit conditions for borrowers remained considerably tighter than in the early 2000s.

Farmland valuations remained elevated

Farmland prices increased since the May report, reaching values near the peak of their historical distribution (figure 1.20). Similarly, the ratios of farmland prices to rents remained historically high (figure 1.21). These high valuations were driven by strong agricultural commodity prices, limited inventory of farmland, and significant increases in cropland revenues that had more than offset higher operating costs.

 

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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