Board of Governors of the Federal Reserve System

1. Asset Valuations

Asset valuations remained elevated relative to fundamentals

Since the April report, valuations continued to rise in U.S. equity markets from already high levels and remained stretched in corporate debt markets. Across equity and some debt markets, liquidity remained low, which can amplify the impact of shocks on financial asset valuations. Indeed, there is some evidence that investors seeking to exit a trading strategy known as the yen-carry trade contributed to a temporary spike in market volatility at the start of August. The yen-carry trade is a leveraged trade relying on a large amount of borrowing in Japanese yen. Investors then use the borrowed funds to invest in other currencies to take advantage of interest rate differentials. Following the Bank of Japan's interest rate increase and weaker-than-expected labor market indicators in the U.S., investors sought to deleverage their yen-carry trades, leading to heightened volatility across many markets.

In U.S. property markets, residential real estate valuations remained near the peak levels seen in the mid-2000s. CRE market conditions continued to deteriorate, especially for the office and multifamily sectors. 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 two largest asset markets are those for equities and residential real estate, which are substantially larger than the next two biggest markets, Treasury securities and CRE. The table also shows recent and historical growth rates for each asset class, because assets experiencing strong growth can be a sign of high risk appetite with respect to that sector.

Table 1.1. Size of selected asset markets

Treasury yields fell but remained high relative to the past 15 years

Since the April report, the Treasury yield curve steepened, with the 2-year Treasury yield falling below the 10-year yield, owing in part to expectations that monetary policy would become less restrictive. However, yields remained well above their average levels over the past 15 years (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—was near the top of its range since 2010 (figure 1.2). Interest rate volatility implied by options remained elevated by historical norms (figure 1.3), reflecting, in part, high uncertainty about the economic outlook and the associated path of monetary policy as well as heightened sensitivity to news about output growth, inflation, and the supply of Treasury securities.

Equity market valuations are elevated

The ratio of equity prices to expected 12-month earnings, or the P/E ratio, which at the time of the April report was already in the upper end of its range since 1989, continued to climb (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)—remained well below its historical median (figure 1.5).² Option-implied equity market volatility rose, on net, after briefly spiking in early August (figure 1.6).³ That said, it remains near the median of its historical distribution.

Spreads in corporate debt markets remained low

Yields for investment- and speculative-grade bonds fell moderately since the April report (figure 1.7) and more than comparable-maturity Treasury securities, resulting in slightly lower spreads. Corporate bond spreads remained low relative to their historical distributions (figure 1.8). However, the excess bond premium for all nonfinancial corporate bonds—a measure of the risk premium required by bond investors after controlling for bond characteristics and credit quality—stayed around its long-run mean (figure 1.9). In addition, nonprice indicators did not suggest elevated risk appetite. For example, the share of deep junk corporate bond issuance—the fraction of bonds rated B- or lower relative to total non-investment-grade issuance—hovered around low levels in the second quarter of 2024. Market-based forecasts of one-year-ahead default probabilities (a forward-looking indicator of credit quality) of nonfinancial firms remained somewhat elevated by historical standards.

Since the last report, the average spread on leveraged loans in the secondary market stayed moderately below its average over the past decade (figure 1.10), and the year-ahead expected default rate remained somewhat elevated relative to its historical average level.

Market liquidity remained low by historical standards

Market liquidity refers to the ease 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 continued 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, suggested that liquidity in the Treasury cash market remained low by historical standards, especially in the on-the-run segment (figures 1.11 and 1.12). However, liquidity is affected by volatility, and recent levels of liquidity partly reflected 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 responded to orders quickly enough to prevent trades from exhausting best-price quotes and amplifying volatility in Treasury markets. Overall, liquidity 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 stayed close to their lowest levels since the 2007–09 financial crisis. In contrast, liquidity conditions in equity markets remained low relative to their longer-term distribution since the financial crisis and deteriorated somewhat further after the early August spike in equity volatility (figure 1.13).

Commercial real estate prices were little changed

Aggregate CRE prices measured in inflation-adjusted terms were little changed since the April report, with the previous pace of declines appearing to have slowed over the past six months broadly across CRE sectors (figure 1.14). However, these transaction-based prices still may not 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. The strains on the office sector resulting from an ongoing post-pandemic adjustment have continued to mount. Vacancy rates for offices located in central business districts increased further, albeit at a slower pace, and nominal rents were about flat since the April report. Vacancy rates also have risen for multifamily and industrial properties, and rent growth has weakened for these types of properties. Capitalization rates at the time of property purchase, which measure the annual income of commercial properties relative to their prices, remained near the low end of the historical distribution, but the high uncertainty about lags in the declines registered by CRE price indexes and fundamentals across CRE markets makes them less reliable in assessing CRE valuation pressures (figure 1.15). In the July 2024 Senior Loan Officer Opinion Survey on Bank Lending Practices (SLOOS), banks reported having tightened standards for all CRE loan categories again in the second quarter of 2024 (figure 1.16).⁴ Most banks indicated that the current levels of standards for CRE loans were at least somewhat tighter than the midpoint of their historical distribution over the past 20 years.

Residential real estate prices remained high relative to fundamentals

Valuations in the residential real estate sector continued to increase since the April report from levels that were already elevated relative to historical standards. The growth of house prices continued through August of this 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 remained stretched. Moreover, an alternative measure of valuation pressures (which uses owners' equivalent rent instead of market rents and has a longer history) also suggested elevated valuations (figure 1.18). The median price-to-rent ratio measured across a wide distribution of geographic areas was little changed over the first half of 2024, around its previous peak in the mid-2000s (figure 1.19). In contrast to the early-to-mid 2000s, lenders have not shown the high risk appetite that fueled excessive borrowing in that earlier period, suggesting that weak credit standards are not driving recent house price growth. For example, banks reported in the SLOOS that standards for residential real estate loans were on the tighter end of their historical range since 2005.

Farmland valuations remained high relative to farm income

Farmland valuations remained elevated, as in 2024 U.S. farmland prices continued to rise past the previous peak of the historical distribution (figure 1.20). Farmland price-to-rent ratios hovered around a level roughly 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.

 

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 2. This estimate is constructed based on expected corporate earnings for 12 months ahead. Return to text

 3. Realized volatility also briefly spiked in August (figure 1.6, blue line), and market-based perceptions of downside risk, which are measured as the cost of insurance against a 10 percent price decline in equities over a monthly horizon, rose, on net, since the April report. Return to text

 4. The SLOOS results reported in the this report are based on banks' responses weighted by each bank's outstanding loans in the respective loan category and might therefore differ from the results reported in the published SLOOS, which are based on banks' unweighted responses. Return to text