<!DOCTYPE HTML PUBLIC "-//W3C//DTD HTML 4.0 Transitional//EN"> <!-- #include virtual = /includes/mc_header.asp --> <!-- Page Title - Change Date --> <HTML> <HEAD> <META http-equiv=Content-Type content="text/html; charset=unicode"> <style type="text/css"> <!-- body { margin-left: 20px; margin-top: 20px; margin-right: 15%; margin-bottom: 20px; } --> </style></HEAD> <BODY bgcolor="#FFFFFF"> <div align="center"> <h1>Annaly Monthly Market Commentary: October 2004 (posted 11/10/04)</h1> </div> <!-- End Title --> <p><b>Focus</b><br> <ul> <li><b>The Economy:</b> <SPAN style="COLOR: black"><EM>Markets remove one uncertainty-the election-but many others are left</EM></SPAN> <li><b>The Mortgage Market:</b> <SPAN style="COLOR: black"><EM>Refinancing activity stays muted as mortgage rates stay in a range</EM></SPAN> <LI><b>Interest Rates:</b> <SPAN style="COLOR: black"><EM>We contemplate the Fed's next "measured" rate increase& and beyond</EM></SPAN></LI> </ul> <p><b>The Economy</b></p> <p><br> The only reason the FOMC did not raise the Federal Funds rate in October was because there was no meeting during the month. However, most market participants expect that the Fed will stay true to its word and continue its "measured" pace of increases when it next meets on November 10. The Fed Funds futures market is putting it at a greater than 100% certainty that at the November 10 meeting the FOMC will raise the overnight lending rate to 2.0%, making it the fourth consecutive FOMC meeting with a 25 basis point increase since June 30. But the market and economists are now debating about what will follow. To what level will the Federal Reserve need to tighten the Fed Funds rate in order to keep economic activity humming at its potential level while maintaining stable prices? Any rate below that level would be considered accommodative and incite inflationary pressures, and any rate above that level would be considered contractionary. Most economists believe that this magic level for the Fed Funds rate is somewhere in the 3.5% to 4.5% range. One of the key determinants of this neutral rate is demonstrated and expected inflation, but inflation data is still sluggish, as the latest core personal consumption price index rose at just a 0.7% annual rate. "If Fed officials thought inflation would stay that low going forward," wrote John Berry in Bloomberg on November 1, "they might not even raise rates next week." It is an interesting rhetorical flourish, but unlikely given the oft-stated concerns over the pressure that high oil prices may have on the economy, the recently reported 3.7% increase in third quarter GDP, rising durable goods orders, strong retail sales and new home sales.</p> <p>So when will the Fed stop? To shed more light on what may happen, we take note of speeches delivered by two Fed officials in October. The first was given by Fed Governor Ben S. Bernanke on October 7 called "Central Bank Talk and Monetary Policy". In it, Bernanke lectures that the Fed tries to telegraph its intentions as clearly as possible in order to be as credible as possible with the securities markets. "Indeed," Bernanke said, "if the central bank's statements are not informative about the likely future course of the short-term interest rate, they will soon lose their ability to influence market expectations. Rather, the value of more-open communication is that it clarifies the central bank's views and intentions, thereby increasing the likelihood that financial-market participants' rate expectations will be similar to those of the policymakers themselves-or, if views differ, ensuring at least that the difference can not be attributed to the policymakers' failure to communicate their outlook, objectives, and strategy to the public and the markets." From this speech we conclude that the Fed wants the market to trust that its actions will match its public utterances. In its latest statement the Fed calls its monetary policy "accommodative" with a promise of "measured" rate increases. If Bernanke is to be taken at his word, any change to current policy will be foretold in FOMC statements.</p> <p>The second speech was given by Fed Vice Chairman Roger W. Ferguson, Jr. on October 29 entitled "Equilibrium Real Interest Rate: Theory and Application." Ferguson argued that there may be circumstances which would prompt the Fed to raise rates to a level that is below the neutral rate. "[I]n my judgement," he said, "the lingering hesitancy of businesses to make commitments, the restraint imposed on domestic consumers from an increase in the cost of energy, and the drag on domestic production from the excess of imports over exports all represent forces pulling the equilibrium real federal funds rate below its perceived longer-term level. And, in the context of well-contained inflation, the evidence of remaining underused resources gives us a good reason to hold the real rate below even the intermediate-run notion of its equilibrium to allow the economy to be firmly set on a path that will shrink the pool of these underused resources over a reasonable period." Taking Bernanke and Ferguson together, we conclude that the Fed will be transparent about its future course of policy through its FOMC statements, and that the Fed may not feel the need to raise the Fed Funds rate from its current level all the way to the consensus estimate of 3.5% to 4.5% neutral or equilibrium rate. In addition, this also implies less volatility in the Treasury market which, all other things being equal, is a good environment for mortgage-backeds.</p> <p>We write this commentary in the immediate aftermath of the presidential election. John Kerry has conceded and George W. Bush has won his second term, and fairly convincingly, too. The immediate market reaction has been for stocks to rise, bonds to fall and the dollar to weaken. "Nature abhors a vacuum and markets abhor uncertainty," said Michael Farrell, CEO of FIDAC. "A decisive Bush victory removes uncertainty about many aspects of our economic future. It is now likely that tax cuts stay in place and a pro-business legislative agenda continues. It also means staying the course in Iraq. I don't think that the outlook for the Federal budget deficit improves in the second Bush administration, and this will make it difficult for bonds." Indeed, on November 1 the US Treasury reported that it would be borrowing $100 billion in the fourth quarter of 2004 and a record $147 billion in the first quarter of 2005.</p> <p>Even though election uncertainty has been removed, there are still several serious and not easily solved economic and market issues for the presidential victor to address. First is the economy, which despite all the fiscal and monetary stimulus that has been brought to bear in the last three years is still struggling to consistently create jobs, ramp up manufacturing and incentivize businesses to invest their cash for growth. Second is the stubbornly high price of oil. Third is the twin deficits-budget and current account. The federal government has to meet many needs with its available resources of revenues and borrowing capacity-defense, homeland security and domestic issues such as healthcare, education and infrastructure. In addition, the long-term problems of a Social Security system that may not have enough to pay out promised benefits to the demographically large, soon-to-retire Baby Boomers, corporate pension funds that will fall short of their obligations and an intractably money-losing airline industry adds to the potential mouths to feed. Fourth, if US manufacturers were selling more goods both domestically and abroad, this would help on the revenue side, but the world does not seem to operate this way. The US is the world's biggest consumer, and the world's biggest borrower, and the global marketplace shows no sign of changing this state of affairs without a change in the value of the dollar or the emergence of a new economic superpower. This brings us to China, which is certainly becoming an engine of economic growth in Asia. China's recent announcement that it is raising its official overnight lending rate by precisely 27 basis points to 5.58% is significant not for its size (no one truly expects it to have a significant effect on an already hot economy) but for the mere fact that the People's Bank of China used this tool for the first time in 9 years. We view the rate hike as a small step towards a currency revaluation-up relative to the dollar- a move that would help slow economic growth much more than a small increase to the short-term lending rate.</p> <p>Fifth, the American consumer has become increasingly leveraged. The ratio of household debt to disposable income now stands at 1.2:1, a record. Alan Greenspan recently devoted an entire speech to this issue; rather than raise alarms, however, he tried to soothe any concerns. "Although I scarcely wish to downplay the threats to the US economy from increased debt leverage of any type," he said, "ratios of household debt to income appear to imply somewhat more stress than is likely to be the case." One of the main arguments he used in calming fears on this point is the fact that the household debt-service ratio and financial obligations ratio have peaked and actually been trending flat to down in recent quarters. The household debt service ratio is an estimate of the ratio of debt payments to disposable personal income. Debt payments consist of the estimated required payments on outstanding mortgage and consumer debt. The financial obligations ratio adds automobile lease payments, rental payments on tenant-occupied property, homeowners' insurance, and property tax payments to the debt service ratio.</p> <br> <!-- image --> <div align="center"> <IMG alt="Household financial burdens ease, not rise" src="./10_04_chart.gif" border=0 ></div> <!-- end image --> <br> <p>These issues are not new, and they certainly are not new to the Bush Administration. With a few more seats in the House of Representatives and the Senate, perhaps fiscal policy will change, but we will continue to watch all of the relevant news and statistics to assess the impact of these economic conditions on the markets and our strategy. Going forward, we don't expect there to be much deviation from past policies and believe that the fundamentals for our strategy will continue to be positive. </p> <p><b>The Mortgage Market</b></p> <p><br> Aggregate fixed rate mortgage prepayments came in relatively flat for the month of September (October reporting period), posting speeds that were mostly on par with last month's numbers. As we discussed in our last Commentary, the mortgage borrower's response to the recent drop in rates has been rather muted. Evidence of this can still be seen with the continually tame 2000ish levels of the MBA Refinancing Index. Thus, going forward through the Fall of 2004, most dealer prepayment expectations call for slight increases (5-10%) in mortgage prepayments despite the current lower rate levels.</p>Elsewhere in prepayment land, speeds on Adjustable Rate Mortgages (ARMS) slowed for the month but remained elevated when compared to fixed rate mortgages with similar refinancing incentives. This phenomenon is mostly expected as the shorter borrower horizon that is typically associated with the adjustable rate borrower results in relatively fast baseline speeds. However, despite these faster speeds, ARMS remain attractive within our strategy when compared to other short duration mortgage assets. In other words, on a relative basis to other MBS with similar interest rate risk, ARMS appear to provide the best return under different scenarios for interest rates and prepayments going forward. </p> With Treasury rates remaining mostly range bound for the month of October the mortgage market performed fairly well as prepayment fears have not surfaced, despite flirting with sub 4.00% 10-year yield levels, and worries regarding any fallout from FNMA accounting issues have been subdued. As it stands now, the tightening of mortgage spreads since the FNMA accounting news would suggest that investors continue to have faith in the credit quality of their MBS holdings and have used any instances in spread widening to add to their holdings. We also remain confident that the fundamentals for the mortgage market remain intact, and believe any spread widening over the next several months as the Securities and Exchange Commission sorts out the FNMA accounting issues could represent good buying opportunities. </p> <p><b>The Markets</b></p> <p><br> In October, the yield curve flattened slightly, with both the 10-year Treasury and 2-year Treasury coming down in yield. Stocks rallied tentatively ahead of the election. Gold rose, and oil spiked mid-month to a new record. The MBA Refi Index rose as rates dipped.</p> <br> <!-- image --> <div align="center"> <IMG src="./mc_image_10_04.gif" alt=chart WIDTH="576" HEIGHT="224" border=0></div> <!-- end image --> <!-- #include virtual = /includes/mc_footer.asp --> </BODY> </HTML>