Annaly/FIDAC Monthly Market Commentary: July 2005
(posted 8/9/05)

FOCUS

• The Mortgage Market : Prepays rise, but should taper off in the Fall; GSEs back on the legislative agenda
• The Economy : Greenspan still moves the market; return expectations for investors are coming down
• The Markets : Rates rise across the curve

The Mortgage Market

Mortgage prepayment speeds increased about 17% in June (released in July) for fixed rate and adjustable rate mortgages, which was in line with most expectations. Looking forward, speeds are expected to increase further as the lower rate environment of June and July works its way through the mortgage pipeline during the next two months. Hence, we would expect to see prepayments increase through August and then start to abate into the Fall of 2005 if the yield on the US 10-year Treasury stays near 4.30%. The MBA Refinancing Index has begun to reflect this potential slowdown as it has decreased by 19% since the beginning of July.

Fannie Mae and Freddie Mac were in the news again this month as proposals for Government Sponsored Enterprise (GSE) reform remain in focus among Republicans and Democrats. In July it was the Senate’s turn. Senate Banking Committee Chairman Richard Shelby (Republican) introduced a bill that contains stricter limitations on portfolio size than the Baker-Oxley bill passed by the House Financial Services Committee in May. Although it does not impose explicit limits, the Shelby bill includes a list of “permissible assets” that would most likely call for the GSEs to reduce their investment portfolios either through security sales or by letting them amortize down. We believe that if this scenario were to occur, amortization would be used in order to reduce their investment portfolio holdings so as to not disrupt the mortgage market. Additionally, although the Shelby bill was approved by the Senate Banking Committee, it passed strictly on party lines and may not gain enough bi-partisan support to pass in the full Senate. Besides the stricter portfolio limits that the Shelby bill imposes, opponents of the bill, mostly Democrats, will also not like that it lacks a provision for the GSEs to contribute 5% of their after-tax income to promote affordable housing. The disagreement on these two issues makes it less likely that we will see legislation pass this year. Nevertheless, we continue to view the situation as debt-investor friendly as the legislative mindset does not seem to reduce government support but to fortify safety and soundness at the GSEs.            

The Economy

As leveraged investors in mortgage-backed securities, we necessarily occupy ourselves with the study of interest rates. Our daily experience involves developing possible interest rate scenarios and then simulating them in order to conduct relative value analysis on our portfolios. Knowing that the interest rate market is anything but provincial, we have always monitored economic indicators and monetary and fiscal policy, both in the US and abroad, examined historical precedents and mulled over the latest Fed pronouncement. We read the financial press, independent economic analyses and Wall Street research. All of this work certainly helps us hypothesize why something has happened, but it doesn’t serve us, or anyone for that matter, very well when it comes to predicting what will happen. Accurately forecasting interest rates is practically impossible. Just ask the Wall Street consensus, which has (wrongly) predicted higher long-term rates for years. And then there are exogenous events that no one can predict. For example, if you had asked us in June what the reaction of the markets would be if during July there would be terrorist acts in London, Iraq, Sharm-el Sheikh and Netanya, the Chinese revalued the renminbi and King Fahd of Saudi Arabia died, our answer would probably have been wrong. Each of these events was potentially critical to currencies, bonds and stocks around the world, but perhaps the bigger story is that while there were momentary trading blips, we could discern no large scale revaluation taking place in the markets.

Nevertheless, it was indeed an active month in rates, as the 10-year treasury and the 5-year treasury declined almost 2 points, the 2-year treasury declined by 16/32 and even the 6 month T-bill declined 5/32. On a yield basis, the 2 year Treasury yield rose 38.2 basis points to 4.019%, and the 10-year Treasury rose 36.3 bp to 4.278%. There were a lot of bullish data released during the month which may have contributed to the (long-awaited, much forecasted but oft-delayed) sell-off at the long end--including record existing home sales; a second consecutive month of growth in the Institute for Supply Management’s survey of manufacturing activity; a reduction in the White House’s estimate for the fiscal 2005 budget deficit to $333 billion from a record $427 billion due to higher tax revenues; a surprising decline in the trade deficit; a rise in factory capacity utilization to 80%, the highest level since 2000; a jump of 0.9% in industrial production, twice as fast as the consensus forecast; an unchanged producer price index; and a strong non-farm payrolls report for July showed jobs increasing by 207,000. The inventory-to-sales ratio in the US remains at a record low, which has many economists talking about stronger growth in the second half as businesses build inventories back up.

The data and exogenous events may have had a hand in market returns during the month, but the sell-off more likely came from the usual suspect, Alan Greenspan. Only six months from retirement, Chairman Greenspan proved that he is still as big a force as ever in the eyes of the market. His semi-annual testimony on Capitol Hill was decidedly hawkish. “[O] ur baseline outlook for the U.S. economy,” he said, “is one of sustained economic growth and contained inflation pressures. In our view, realizing this outcome will require the Federal Reserve to continue to remove monetary accommodation.” A day later, the Federal Reserve released the minutes from the last FOMC meeting, in which members focused on inflation: “[S]ome participants expressed concern that, with policy still accommodative, the underlying pace of inflation might be in the process of stepping up, perhaps to a level that was at the upper end of the range that they viewed as compatible with the Committee’s price stability objective. The degree of slack remaining in labor and resource markets was very uncertain, and unit labor costs in the nonfarm business sector had moved notably higher in recent quarters. Trend unit labor costs could also be boosted by slower growth in structural productivity; while recent evidence was not conclusive, some participants thought the underlying pace of productivity growth might well fall back in coming quarters following the substantial gains seen in recent years. And with higher energy prices already eating into profit margins at firms outside the energy sector, increases in unit labor costs might be more likely to be passed through into prices.”

Taken together, these two Fed statements prompted the market to revise expectations about future Fed tightenings. This reaction was personified by David Rosenberg, North American Economist for Merrill Lynch, changing his outlook. “We are making some adjustments to our Fed Funds rate and yield curve forecast in the wake of the hawkish testimony delivered by Fed Chairman Greenspan….Mr. Greenspan signaled loud and clear that the current rate-hiking program is far from being finished.” Rosenberg now believes that the Fed will hike the Fed Funds rate to 4.0% by the end of the year, with an outside chance at 4.25%. Rosenberg is not unique in his forecast. The monthly survey of 65 economists by Bloomberg reveals a median forecast of 4% by the end of 2005. As the graph below shows, the Fed Funds futures market agrees.

From what we can tell, return expectations for investors are starting to be adjusted downward. In his latest commentary, bond manager Bill Gross of Pimco said that if nominal GDP growth is expected to be 5% or less in the future, then “average asset returns will be 5% or less, pre-tax. Investors that earn more will have to take risk...[and those investors] should expect no more than 6-7% going forward.” If by risk one means credit risk, we know what Mr. Gross means: The yield to worst on the Lehman High Yield Index today is 7.59% and the average dollar price is 100.45, meaning that there would have to be upside to that dollar price in order to get a higher return. Martin Barnes, editor of the highly regarded Bank Credit Analyst, was in Barron’s this weekend saying that a world of low inflation means “stocks may get 5% or 6% and bonds get 4% and cash will get 3% returns. Those are returns I see in the next decade.” Another perspective on returns came from Christopher Davis of Davis Funds, who observed in a WSJ interview that in order for US stocks to average an annualized return of 7% during the decade ending in 2010, they would have to return 17% per year from now until 2010. We don’t believe anyone is looking for 17% annually from stocks over the next five years.

The Markets

The biggest gainer during the month was the yield on the 2-year Treasury. Year over year, the 2-10 spread has narrowed from 179.6 bp to 25.9 bp. Stocks had a strong month and oil finished above $60. Note that we have added long-term rates around the world to our markets table. Note further that short-term US rates are the only rates that are rising year-over-year.

This commentary is neither an offer to sell, nor a solicitation of an offer to buy, any securities of Annaly Capital Management, Inc. (“ Annaly”), FIDAC or any other company. Such an offer can only be made by a properly authorized offering document, which enumerates the fees, expenses, and risks associated with investing in this strategy, including the loss of some or all principal. All information contained herein is obtained from sources believed to be accurate and reliable. However, such information is presented “as is” without warranty of any kind, and we make no representation or warranty, express or implied, as to the accuracy, timeliness, or completeness of any such information or with regard to the results to be obtained from its use. While we have attempted to make the information current at the time of its release, it may well be or become outdated, stale or otherwise subject to a variety of legal qualifications by the time you actually read it. No representation is made that we will or are likely to achieve results comparable to those shown if results are shown. Results for the fund, if shown, include dividends (when appropriate) and are net of fees. ©2005 by Annaly Capital Management, Inc./FIDAC. All rights reserved. No part of this commentary may be reproduced in any form and/or any medium, without express written permission.