Fed flags overheated markets as top stability risk

• Key takeaway: The Federal Reserve said market froth remains the leading risk to financial stability, consistent with its assessment in November.  
• Expert quote: “Treasury market liquidity initially deteriorated in line with this heightened volatility, demonstrating the vulnerability of market liquidity during periods of acute stress.” —Federal Reserve Financial Stability Report.
• What’s at stake: The report comes as the economy faces turbulence with the Iran war driving up energy prices and raising potential implications for inflation depending on how long the conflict lasts.

The Federal Reserve on Friday flagged elevated asset prices and continued investor optimism as risks to financial stability. 

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In its latest Financial Stability Report, which comes out twice a year, the central bank said asset valuations, including stocks and other securities, remain “at the high end of their range in most markets.”

“Measures of broad equity valuations remained elevated. Corporate bond and loan spreads continued to be low by historical standards,” the report said.

Despite ongoing market optimism, the Fed said investors are beginning to demand more compensation for risk as uncertainty around monetary policy increases.

“Treasury yields across 2- and 10-year maturities rose modestly since the November report and remained well above their average levels over the past 15 years,” the report said. “Interest rate volatility implied by interest rate swaptions moved higher in March but subsequently retreated, leaving it little changed, on net, and near its long-term median.”

The Fed said geopolitical risks tied to developments in the Middle East contributed to periods of heightened interest-rate volatility, particularly in shorter-term Treasury securities.

“Treasury market liquidity initially deteriorated in line with this heightened volatility, demonstrating the vulnerability of market liquidity during periods of acute stress. In subsequent weeks, liquidity recovered, and, on net, market depth — a measure of liquidity in the Treasury market — was little changed since the previous report.”

The report, which includes data through April 23, said equity markets remain supported by investor optimism, though volatility has increased.

“Two measures of equity market volatility — option-implied and realized — increased since November, with option-implied equity volatility moving to a level above its historical median,” the report said.

The Fed said commercial real estate prices have shown signs of stabilization following declines in 2022 and early 2024, as vacancy rates and rent growth normalized. In residential real estate, it said house-price growth continues to moderate, though prices remain elevated.

The report also highlighted elevated leverage among financial institutions, particularly hedge funds and life insurers. It said leverage at the largest life insurers and at hedge funds remains “well into the upper quartile of its historical distribution.”

“Life insurers have also steadily increased their investments in risky and illiquid assets over the past decade, and their activity has contributed to the expansion of private credit,” the report added.

The Fed said the banking sector remains “sound and resilient,” citing historically high regulatory capital levels and reduced interest rate risk as banks shorten asset duration. It added that strong profitability continues to support capital accumulation as banks retain earnings rather than rely on external funding.

Household and business debt risks were described as “moderate,” with total debt falling relative to the size of the economy. Mortgage delinquency rates remained historically low, though some stress has emerged in Federal Housing Administration loans, which have seen delinquencies rise above pre-pandemic levels.

The report also included results from a Federal Reserve Bank of New York survey on market risks. Geopolitical risk ranked as the top concern, cited by more than 75% of respondents, up from 50% in November. Oil shocks ranked second at 70%, while artificial intelligence and private credit were each cited by 50%.

The survey included 20 market contacts polled between March and April.