Annaly Monthly Market Commentary: January 2005 (posted 2/7/05)
Focus:
•The Mortgage Market: Prepayment speeds rise slightly
•The Economy: The beginning of the end of the American productivity miracle?
•The Markets: The yield curve flattened as short rates rose
The Mortgage Market
Aggregate fixed-rate and hybrid ARM prepayments came in as expected for the month of December (January reporting period), posting speeds that were flat to slightly higher than last month’s numbers. Despite a recent spike in the MBA Refinancing Index above the 2000 level, most dealer forecasts are looking for January speeds to slow 5-10% as seasonal factors take hold. Looking forward, as long as mortgage rates remain at or above current levels, expectations for any large pick up in prepayment speeds for early 2005 remain relatively muted. A level of above 3000 on the MBA Refinancing Index would cause us to change our view and increase prepayment expectations. However, we do not see such an event occurring unless the yield on the 10-year US Treasury dips below the 4.00% level for a considerable amount of time.
Spreads on mortgage products have remained stable through the first month of 2005 as any supply has been met by more than enough demand from investors. As 2005 unfolds, most market players believe the risk to a major widening in mortgage spreads is unlikely as interest rates remain range-bound, prepayments remain muted and demand from investors who need to put cash to work continues to be strong. A break in the relatively stable trading range of US Treasury rates could cause views to change as the mortgage market may begin to worry about prepayment risk in a rally or extension risk in a sell-off. Nonetheless, we believe any of these environments would still provide opportunities to deploy capital within our strategy.
The start of the year promises to bring more of the same in terms of headline risk for Fannie Mae and Freddie Mac as GSE regulatory reform is likely to be an important item for Congress in 2005. Recently a bill was proposed in the Senate that seeks to establish a new GSE regulator with the power to adjust minimum capital standards, approve new lines of business for the GSEs and the power to liquidate assets of a GSE that is in default (receivership). A bill that contains the receivership provision, if passed, could cause rating agencies to reflect upon the current AAA rating on GSE debt, although it is unclear if a downgrade in rating would be warranted. Interestingly, agency debt spreads had no reaction on the news and closed the month mostly unchanged. Undoubtedly, the debate in Congress on GSE regulatory reform will be an ongoing phenomenon in 2005. While we will watch carefully as events unfold, the marketplace, as evidenced by stable MBS spreads, remains content that the result will only have a limited effect on Agency mortgage-backed securities holders due to their several levels of credit protection.
The Economy
In a period in which the Federal Reserve is not raising or lowering rates, economic analysis has a different pace, a different focus. If the Fed were not in a tightening cycle right now, we would be considering such various current topics as the debate in the US over social security and tax reform, the comments made in last week’s G-7 meetings vis-à-vis currency valuations or Alan Greenspan’s speech on the likelihood of the US current account deficit declining. We would examine the persistent trade gap, Japanese bond yields, growth in
Since the Federal Reserve is on a tightening rampage right now, however, the more immediate focus of our thinking has to be how much and how long funding costs continue to rise. Given the emphasis on transparency in communications, the Fed will likely let the market know in an FOMC statement when its policy of “measured” increases in the Fed Funds rate is due for a change. Until that time, we are left with little more than educated guesses about how far and how fast the Fed will go. From its FOMC statements, it is clear that the Fed watches economic activity in a broad sense—including the labor market and resource utilization—as well as inflation and longer-term inflation expectations. There is one factor in the Fed’s thinking that, because of its ubiquity, had been almost taken for granted until very recently. That factor is productivity. After stating that the Fed Funds rate was being raised another 25 bp on February 2, the Committee said that even with this action “the stance of monetary policy remains accommodative and, coupled with robust underlying growth in productivity, is providing ongoing support to economic activity.” The Fed has been featuring productivity growth in its FOMC statements since mid-1999, and versions of the phrase “robust growth in productivity” have appeared in virtually every statement since August 2002.
Productivity growth has indeed been robust in recent years. According to the Bureau of Labor Statistics, which tracks the data, productivity is defined as “a measure of economic efficiency which shows how effectively economic inputs are converted into output. Productivity is measured by comparing the amount of goods and services produced with the inputs which were used in production.” The most commonly cited measure of this is labor productivity, which is the relationship between output and the labor time used in generating that output. The most-followed series is expressed as the ratio of output in dollars per hour for non-farm businesses. By this measure, the average annual growth in productivity from 1948 (when the BLS started the data series) through 2004 was 2.3%. From 2000 to 2004 the average rate of growth in productivity was 3.64%. The last three, five, and seven years through 2004 have been the highest of any period of similar length since 1948. “While the post-1995 period includes the boom of the late 1990s,” wrote Jorgenson, Ho and Stiroh of the Federal Reserve Bank of
Much of the credit for the productivity miracle in the
What if the trend in productivity growth were to reverse? What effect would it have on the economy and, therefore, the Federal Reserve’s policies? If companies, which have vigorously cut costs and held hiring down, begin to hire workers, pressure on wages would likely lead to inflation. The graph above illustrates the strong correlation between GDP growth and the concurrent economic indicator nonfarm payroll growth, as well as the relative disconnect with core inflation. Not only can we infer that non-farm payroll growth is weaker in this recovery due to productivity growth, but we can also suggest that core CPI may be picking up as productivity declines and hiring picks up speed. Productivity growth may indeed be at a turning point. According to the most recent data released by the BLS, on an annual basis, non-farm business productivity in the
Many Fed officials in recent weeks have talked about productivity changes as they relate to Fed policy. Fed Vice Chairman Ben S. Bernanke addressed these questions in a speech to the Council on Foreign Relations on January 19. He concluded: “[T]he principal effect of an unexpected slowdown in productivity growth during the next few years would likely be higher inflation, with the short-term impact on the growth of output and employment likely to be relatively minor. In this scenario, the appropriate monetary policy response would be toward less accommodation.” With sentiments like this and a trend that may be changing we will continue to review the data. However, the productivity statistics, including labor costs, are released quarterly, so this is a process which likely plays out over a longer time period. In the shorter run, it is the second-order effects that will give clues, such as the employment data, the producer and consumer price indexes and capital spending.
The Markets
While the 10-year Treasury is virtually unchanged from a year ago, the 2-year Treasury is up almost 80% in yield. The dollar strengthened in January, gold weakened and oil rebounded. The MBA Refinancing Index increased in January as mortgage rates dipped slightly.
MOM % change |
YOY % change |
||||
Federal Funds Rate |
2.25% |
2.25% |
1.00% |
0% |
125% |
2-year Treasury |
3.276% |
3.069% |
1.823% |
6.7% |
79.7% |
10-year Treasury |
4.130% |
4.220% |
4.134% |
-2.1% |
-0.1% |
30 yr conventional mortgage |
5.45% |
5.53% |
5.54% |
-1.4% |
-1.6% |
Dollar Index |
83.57 |
80.85 |
87.20 |
3.4% |
-4.2% |
Japanese Yen |
103.57 |
102.50 |
105.82 |
1.0% |
-2.1% |
S&P 500 |
1181.27 |
1211.92 |
1131.13 |
-2.5% |
4.4% |
Nasdaq Composite |
2062.41 |
2175.44 |
2066.15 |
-5.2% |
-0.2% |
Gold $/oz (nearby contract) |
$421.80 |
$438.40 |
$402.20 |
-3.8% |
4.9% |
Oil $/bbl (nearby contract) |
$48.20 |
$43.45 |
$33.05 |
10.9% |
45.8% |
MBA Refi Index (month-end value) |
2253.9 |
1701.3 |
3250.6 |
32.5% |
-30.7% |
This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of