Annaly Monthly Market Commentary: December 2004 (posted 1/10/05)
Focus
- The Economy: The Fed weighs the risks of inflation versus growth
- The Mortgage Market: ARM prepayment speeds stay fast while fixed-rate MBS prepayment speeds decline
- Interest Rates: The bond market takes a nap after three challenging months, stocks fall and oil rises
Annaly Monthly Market Commentary: December 2004 (posted 1/10/05)
The Mortgage Market
Thankfully, in 2004 the mortgage market delivered no perfect storm like the one experienced in 2003, but there was still a decent amount of turbulence during the year. Next year will undoubtedly have its share of change as well. Below we take a brief look back at 2004 and offer some thoughts for 2005.
Aside from the mini refinancing wave of March and April, 2004 experienced relatively lower prepayments than 2003, even in the face of persistently low mortgage rates. The MBA Refinancing Index averaged about 2400 for the year compared to 2003’s steamy average of close to 5000. Looking ahead to early 2005, prepayments are expected to remain subdued as long as mortgage rates remain near current levels.
With the slowdown in mortgage refinancing activity, total mortgage issuance in 2004 declined significantly relative to 2003. However, the percentage of alternative mortgage product originations soared in 2004 as borrowers sought to offset the declining affordability of housing financed by traditional fixed rate loans. In particular, hybrid adjustable-rate mortgages and loans with a non-amortization (interest-only) period were popular borrowing vehicles. Morgan Stanley research estimates that about 30% of MBS issued in 2004 were of the adjustable-rate variety, compared to only 14% in 2003. With more financing alternatives at the borrower’s disposal the housing market remained robust, increasing by a record 12.97% y-o-y through the third quarter of 2004, as measured by OFHEO’s Housing Price Index. Although the torrid pace of housing appreciation is not expected to continue, most market participants expect the share of alternative mortgage market products to increase slightly in 2005 as borrowers look for new and different ways to manage their liabilities in the face of rising interest rates.
The Treasury curve flattened 128 basis points between the 2-year and 10-year as the Federal Reserve tightened funding rates over the last half of the year. A flattening curve usually spells trouble for mortgage spreads as funding costs rise and prepayment expectations for premium bonds increase. However, a continually transparent Federal Reserve has led to the market avoiding any major rate shocks so far and interest rate volatility is currently at or near multi-year lows. Correspondingly, along with lower prepayments relative to 2003 and a global reach for yield by investors, declining interest rate volatility has helped to keep mortgage valuations tighter as we finish 2004 and enter into 2005. Looking ahead, despite tighter spreads, the investment environment still offers attractive long term opportunities for our strategy.
Facing tighter spreads and increased asset competition, GSE portfolio growth rates declined significantly during 2004. Also, accounting issues surfaced again when Fannie Mae came under fire regarding its accounting for derivatives. Fannie Mae is now required to restate its financial statements as far back as 2001 and will have to increase its regulatory capital by June 2005 to 30% above the previously required level. As the company is currently undercapitalized in the eyes of its regulator OFHEO, during the last week in 2004 Fannie Mae issued $5 billion in preferred stock to help address their capital adequacy problems. This issuance has somewhat mitigated the mortgage market’s concern that it would see heavy selling of mortgage assets by Fannie Mae in an attempt to boost capital levels. Overall the mortgage market reaction to Fannie Mae’s accounting issues has been muted as most participants feel Fannie Mae has enough options (e.g., retained earnings, mortgage portfolio pay-downs, dividend payout reductions) and time to raise capital levels without selling mortgage securities or disrupting financial markets. Nevertheless, as we go into 2005 the GSEs will remain in the headlines and may continue to show mediocre portfolio growth as their accounting issues are resolved and Congress proposes new legislation on how they should be regulated. Given the modest market participation by the GSEs in 2004 and its lack of major impact on mortgage spreads, we see a slow growth rate by the GSEs in 2005 having a limited effect on the mortgage market in the current investment environment.
The Economy
Looking back at our monthly commentaries in 2004, it is no surprise that our analytical focus was primarily on the Federal Reserve and its decision-making process. This month is no different. While this exercise may certainly be repetitive to close readers (for which we apologize), in this environment it is nevertheless appropriate to use the Fed as the prism through which to view the economy and the financial markets because of its current activism and because of its primacy to our strategy. After all, if the Fed is manipulating the front end of the yield curve, then it is manipulating our cost of funds and the coupons and yields on our assets. Moreover, the reaction of the long end of the curve to Fed policy drives prepayment activity.
What does the Fed think it sees? Its new policy of releasing FOMC meeting minutes within three weeks now gives us two lines of sight on “official” Fed thinking. At its Dec. 14th FOMC meeting, the Fed raised the federal funds rate another 25 basis points to 2.25%. In the accompanying statement, which was virtually unchanged from the prior meeting’s statement, the FOMC stated its belief that even at 2.25% monetary policy was accommodative. It characterized economic output as “moderate”, cited “improve[ing]” labor market conditions and “robust” productivity growth. However, the “measured pace” language did not change because it saw “[i]inflation and longer-term inflation expectations” as being “well contained”. With the release of the meeting minutes, however, we see that the Fed is seemingly much more concerned about inflation than can be inferred from the statement alone. The meeting participants listed a number of developments that could pose risks to the upside for inflation: higher oil prices, the decline in the dollar, expected slowing in productivity growth and the possibility that “the economy could soon be operating close to potential.”
This part of the discussion, as well as general comments on the strength of the economy, led market participants to interpret that the Fed would continue its pace of 25 bp increases for the foreseeable future. We agree. The Fed is not only concerned about its most obvious assignment of maintaining price stability, but we also read hints of a concern about risk-taking in the financial markets and the value of the dollar. Raising the funds rate remains the most obvious tool the Fed can use to address these issues.
The larger question is what happens to the longer end of the yield curve. So far, raising the Fed Funds rate by 125% in just five months has actually led the long end to move down in yield, from about 4.6% at the end of June to 4.22% at the end of December. This market action would seem to be contrary to the Fed’s more bullish view on the economy. Indeed, if the market felt that inflationary pressures and the economic expansion warranted such central bank vigilance, presumably the long end of the curve would be higher. In the minutes, the Fed itself wondered about this. “A few participants commented that the generally low level of interest rates across a wide range of maturities and the recent flattening of the slope of the yield curve (measured as the spread between the ten- and two-year Treasury yields) might signal that expectations of longer-term growth had been marked down.”
There is some truth to that. However, it could also be a reflection of the market staying a few steps ahead of the Fed or the fact that the new Fed transparency has had the unintended effect of increasing the amount of risk-taking in the market. In any event, as we point out below, the yield curve is still relatively steep on a historical basis. We expect the yield curve to continue to stay relatively steep during 2005, even as the Fed continues to tighten. In the Wall Street Journal’s semi-annual poll of Wall Street economists, there is overwhelming consensus that long rates will rise over the next six months. The average forecast of the 56 surveyed economists for the 10 year Treasury yield on June 30 is 4.79%. For us, one of the key determinants of long term rates at this point in the economic cycle is the budget deficit. Running a significant deficit, to us, not only crowds out the competition for capital, but also puts upward pressure on rates as the market demands higher returns. Beyond this, the key economic variables to watch going forward are broadly defined resource usage, such as non-farm payroll growth and capacity utilization, and inflation as measured by core CPI and the PCE deflator. These indicators are generally ticking up. The key external variables for all investors to watch in 2005 are the continued appetite of foreign investors for American securities, the value of the dollar and developments in
The benefit of investing in our strategy is that our view on the future of rates generally does not drive our portfolio composition. Since accurately predicting the future of interest rates is virtually impossible to do, making a directional bet in our investment portfolio would be a speculation. We do not speculate on interest rates. The goal of our strategy is to structure a portfolio that will generate high current income and maintain a relatively stable NAV through a wide range of interest rate environments.
The Markets
In 2004, the yield curve flattened as the Federal Reserve raised the Fed Funds rate 125 basis points while the 10-year Treasury note was relatively unchanged. But that only tells part of the story, as the 10-year had a 119 basis peak to trough swing during the year, from a low of 3.68% to a high of 4.87%. From
After a weak showing in the first part of the year, stocks rallied after the election and the strong November employment report. The dollar continued to slip. Gold finished the year up and oil, while settling at the end of the year peaked over $55 during the year. The MBA Refi Index peaked when rates fell in June, but fell back to lower levels.
YOY % change |
2004 Hi Close |
2004 Lo Close |
||||
Federal Funds Rate |
2.25% |
2.00% |
1.00% |
125.0% |
2.25% |
1.00% |
2-year Treasury |
3.069% |
3.001% |
1.823% |
68.3% |
3.110% |
1.460% |
10-year Treasury |
4.220% |
4.351% |
4.248% |
-0.7% |
4.870% |
3.680% |
30 yr conventional mortgage |
5.53% |
5.59% |
5.56% |
-0.5% |
6.22% |
5.06% |
Dollar Index |
80.85 |
81.82 |
86.92 |
-7.0% |
91.96 |
80.53 |
Japanese Yen |
102.50 |
103.08 |
107.98 |
-4.6% |
114.48 |
102.38 |
S&P 500 |
1211.92 |
1173.82 |
1111.92 |
9.0% |
1213.55 |
1063.23 |
Nasdaq Composite |
2175.44 |
2096.81 |
2003.37 |
8.6% |
2178.34 |
1752.49 |
Gold $/oz (nearby contract) |
$438.40 |
$451.30 |
$416.10 |
5.4% |
$456.00 |
$374.90 |
Oil $/bbl (nearby contract) |
$43.45 |
$49.13 |
$32.52 |
33.6% |
$55.17 |
$32.48 |
MBA Refi Index (month-end value) |
1803.9 |
1912.3 |
1644.30 |
9.7% |
4988.7 |
1363.2 |
