Annaly Monthly Market Commentary: April 2005 (posted 5/6/05)

FOCUS

• The Mortgage Market : Prepayment speeds fluctuate with interest rates
• The Economy : The economy gives the Fed little direction, but the currency and credit markets bear watching
• The Markets : High-yield bonds lose ground, stocks continue their weak 2005

As expected, a large pickup in prepayment speeds (over 30% versus February levels) occurred for the month of March as seasonal slowdowns abated and the increased refinancing activity of early February worked its way through the mortgage origination pipeline. Looking forward, consensus estimates are forecasting a slight slowdown in the coming months but the recent dip in the 10-year US Treasury yield to below 4.20% has some dealers adjusting their expectations upwards. Nevertheless, the faster speeds of March are unlikely to be repeated over the next quarter unless we see a rally in the 10-year yield to around 4.00%. This is evidenced by the lower levels of the MBA Refinancing Index, which in early February reached levels above 2500, but now stands around 2000.   

Mortgages underperformed Treasuries for the month of April as mortgage spreads widened in concert with other spread products. However, compared to credit-related securities, mortgages were a much better performer as corporate credit spreads widened significantly throughout the month because of concerns on the economy hitting a soft patch. Elsewhere in the mortgage market, April provided more news on the GSE reform effort as the Senate Banking Committee held hearings in order to gather opinions and data. During these hearings, the CEOs of Fannie Mae and Freddie Mac delivered testimony (which is available on their respective websites), as well as the outgoing Director of OFHEO (the current regulator of the GSEs) and various other housing market participants. The most relevant and disputatious issue revolves around the growth and size limitations of the GSE portfolios. Critics of the GSEs feel regulatory reform providing portfolio limitations is necessary, while proponents of the GSEs feel that limiting portfolio growth would take an important  source of liquidity away from the marketplace. Some middle ground solution to this issue is most likely and it remains to be seen whether any of the GSE reform measures will have an effect on the mortgage market. Thus far the discussions have had little effect on the mortgage market.    

The Economy

Like a becalmed sailor, the Federal Reserve must try to predict from which direction the next breeze will blow. We believe that the US economy sailboat—and the monetary policy team at its helm—is at a particularly vulnerable and precarious point in the cloudy Foreseeable Future Sea. Will the next economic wind affect sustainable growth or price stability? What should the sailor do? Should he continue on the course of measured tightening in order to pre-empt inflation or tack in the other direction and attempt to sustain the faltering progress of the US economy?

We think the sailor is lost. On May 3, when the FOMC made its eighth 25 bp tightening in eight consecutive meetings, it did little to reveal its thinking on direction, as it left its statement virtually unchanged. Up to this point, the Fed has attempted to provide greater decisionmaking and policy transparency in its statements but, paradoxically, the unending repetitiveness of its language has only made its process more obscure, especially when the data is so evidently changing. On the inflation front, the latest evidence points to stronger inflationary impulses—core CPI rose 0.4% in March, twice as high as forecast, and is running at an annualized rate of 3.3% in the first quarter; the core personal consumption expenditures index rose by 0.3% in March and an annualized rate of 2.2% over the past six months; the import price index rose a greater-than-expected 1.8%; and unit labor costs gained 2.2% in the first quarter, a significant pickup from the fourth quarter’s 1.7% increase. And yet in its statement the Fed kept in the sentence (albeit added later in the day) that said “Longer-term inflation expectations remain well-contained.” On the growth front, the data point to a “soft patch” in the performance of the economy—durable goods orders lost momentum, as both total and core (ex-defense and ex-air) were down, by 2.8% and 1.1%, respectively; growth in business investment on buildings, equipment and software slowed to 4.7% in the first quarter, down from 14.5% in the fourth quarter of 2004; and GDP for the first quarter came in at a slower-than-expected 3.1%, the weakest performance in two years. And yet in its statement the Fed kept to its language from earlier statements that its accommodative stance, coupled with robust productivity gains, were “providing ongoing support to economic activity.” With two months until its next meeting on June 30, the Fed will have a lot more data on inflation and economic growth, and a continuation of these trends will certainly require a change in language, if not policy. Ultimately, however, we believe that the Fed would consider inflation a less desirable outcome than a slowing economy, and the huge +274,000 nonfarm payroll number released on May 6 certainly gives Alan Greenspan the cover to be aggressive in that effort.

There are other developments that the market needs to monitor, because we believe they will be as significant to the financial markets as anything the Fed does. In the currency markets last month, international pressure for China to change its currency policy was ratcheted up to an intense level from the World Bank, G-7 ministers and the Bush administration, and the fallout roiled the currency markets. The governor of the People’s Bank of China, Zhou Xiachuan, acknowledged that the pressure “may force us to speed up our reform”, and the currency even briefly traded outside of its band on April 29. Elsewhere, the Bank of Japan’s closely watched six month economic outlook revealed that the BoJ no longer believes that it is out of the deflationary woods, as it predicted that core CPI would fall 0.1% this fiscal year. And in Europe, holders of euros and assets denominated in euros will watch with bated breath to see how France, a founding member of the EU, votes on an EU constitution. A widely-expected “no” vote may have broad ramifications for euro debt markets and the currency markets.

In the credit markets, S&P’s downgrade of General Motors and Ford to below-investment-grade status on May 5 could be one of those events that six months or a year from now will, upon reflection, have proven to be a watershed in the bond market. To us, it could be the signal that causes investors to re-evaluate credit risk in their portfolios. While spreads between high-yield debt and Treasuries have widened considerably in the last several weeks and high yield returns have been negative year-to-date, we still hear from our contacts in the markets that demand for high yield and distressed debt strategies continues. The downgrades of these stalwarts of the US economy could be the validation of the concept that this is the wrong time to be making a sizeable allocation to credit. Rather, when the Fed is raising the Fed Funds rate 200% in a little over 10 months, long-term interest rates face upward pressure and the economy is slowing, perhaps it is time to be moving out of credit and duration and into high quality short duration assets that generate strong income.

The Markets

During April, interest rates rallied and the curve continued to flatten. US stocks continued to lose ground, as the S&P 500 and the Nasdaq are down year-to-date 4.5% and 11.7%, respectively. Oil eased and gold rallied.

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