FOCUS
Mortgage prepayments, as expected, decreased 5 to 10% for the month of December for fixed-rate and adjustable-rate mortgages as slower winter seasonal factors remained and higher mortgage rates compared to the autumn continued to temper mortgage refinancing activity. Looking forward, dealer forecasts call for a continued decrease in prepayments for January and then an uptick as we emerge from the winter housing doldrums in February and March. The MBA Refinancing index is beginning to reflect this upward trend as the index has moved up by over 35% from its December lows of 1259 to around 1750. Nevertheless, unless there is a significant rally in rates, we still expect mortgage refinancings to be lower relative to last year throughout 2006 as we continue to see signs that the housing market is on a slowing trend. We expect this slowdown to translate into a more stable profile for prepayments on fixed-rate MBS relative to prior years. ARM prepayments should be slower overall, but we expect them to exhibit a more lumpy profile.
As 2006 unfolds we will be concentrating on a few major themes in mortgage land that look eerily similar to the themes we discussed at the beginning of 2005, namely the slowing of the US housing market and GSE reform and how any emerging trends in these areas will affect MBS prepayments and spreads. On the one hand we can now report that it seems we will see at least some signs of a US housing slowdown in 2006, although at this point it is difficult to discern whether the slowdown will be meaningful for MBS and/or the overall economy. Nevertheless, the downward trend is clear. On the other hand, the legislative picture for the GSEs is murkier. It is doubtful that a GSE reform bill will be passed in 2006, for a couple of reasons. First, the Senate and House bills are significantly different. Second, as 2006 is an election year here in the United States there are likely a number of higher priority issues on the congressional agenda than GSE reform, such as national security, healthcare and taxes. Third, unless more accounting troubles are revealed, it would appear that the call for swift GSE reform has subsided as the GSEs have made decent strides to remedy past accounting and operational mistakes. If 2006 does indeed turn out to be a non-event on the legislative front for the GSEs this should be a slight positive for MBS spreads at the margin as Fannie Mae and Freddie Mac will be more active and able to purchase bonds opportunistically.“Maybe.” It’s the answer someone gives when they don’t want to give a definitive answer. It is an answer borne of indecisiveness. It is also the answer the Federal Reserve gave on January 31 to the unspoken question about whether it is done raising interest rates. Until now the Federal Reserve’s three year effort to be more transparent by telegraphing its next policy move has worked well in removing uncertainty, and therefore volatility, from the market. Today, however, this policy is, oxymoronically, giving the market a transparent look at uncertainty. It’s the proverbial tree falling in the forest. While the Fed acknowledges it is almost done, what it will do next is still in play.
Alan Greenspan left office with a parting gift to everyone in the markets: The 14 th straight FOMC meeting with a 25 basis point increase brought the Federal Funds rate to 4.50%. He also left with a change in the FOMC statement that seemed to further back away from committing to more tightening, essentially giving his successor, Ben S. Bernanke, the freedom to call it as he sees it on March 28. “The Committee judges that some further policy firming may be needed to keep the risks to the attainment of both sustainable economic growth and price stability roughly in balance,” the statement said (emphasis added). In so doing, the Fed removed the word “measured” and changed the word “likely” to “may” from the Dec 13 statement. So possibly, maybe, the Fed could hike on March 28, but the statistics coming out between now and then will be closely watched.
The data coming out before the January 31 FOMC meeting were mixed. The US Commerce Department released its advance estimate of GDP growth for the fourth quarter of just 1.1%, the slowest pace in three years and sharply below the consensus forecast. The primary reason for the slow growth was weak business investment spending, but even with that explanation most analysts were left scratching their heads. “It’s hard to recall a more puzzling advance estimate of real GDP,” said David Resler, chief economist of Nomura Securities. “While it is not unusual for forecasters to miscalculate the high frequency (monthly) indicators, it is rare indeed for EVERYONE to be so far off a quarterly GDP number because nearly 2/3 of the inputs to the advance estimate are already ‘known.’ Apparently, much of what we thought we ‘knew’ was wrong.” Resler was surprised by the big decline in defense spending in the quarter, and the strength in real consumer spending.
In the housing market, existing home sales fell 5.7% in December, the months of supply increased to 5.1 months, and the national median sales price declined slightly from $215,000 in November to $211,000 in December. These latest points are a continuation of a cooling trend in housing that likely began last summer. A recent report by Goldman Sachs suggests that the US housing market—and the US economy—is likely to follow the trajectory previously demonstrated by the UK and Australia. In those markets, consumer spending declined by 2 to 3 percentage points in the year following a decline in housing prices, which in turn slowed down their economies by about 1.5 to 2 percentage points. Thus Goldman sees a slowdown in US housing leading to slower consumer spending and reduced GDP growth.
On the corporate front, earnings releases included some strong performers as well disappointment at GE, Intel, Yahoo, Google, Citigroup, General Motors and Ford. Citigroup’s results (as well as Bank of America Corp., J.P. Morgan Chase and smaller banks, too) reflected the difficulty for financial institutions during periods of rising short-term rates. The company cited the “challenging interest rate environment and competitive pricing conditions globally” when it reported a 3% decline in earnings for the fourth quarter. GM lost $4.8 billion in the fourth quarter, while Ford announced a loss of $1.55 billion in North America operations in 2005. Ford, following GM’s lead, also said it was slashing up to 34,000 jobs in North America over the next six years. Ford and GM, both rated below-investment-grade and soon to be passed by Toyota as the world’s biggest automaker as measured by global vehicle sales, need to cut capacity, cut labor costs and restructure their product lines.
The nonpartisan Congressional Budget Office published its budget projections last month and forecast that the annual budget deficit will widen to $360 billion this year due to war and hurricane relief costs. Moreover, the CBO warned that in the years ahead the deficit will likely worsen if tax cuts passed during the Bush administration are extended. Also embedded in the report were warnings that the continued increase in the percentage of the population age 65 or older and the related growth of Medicaid, Medicare and Social Security programs will “exert pressures on the budget that economic growth alone is unlikely to alleviate. A substantial reduction in the growth of spending and perhaps a sizable increase in taxes as a share of the economy will be necessary for fiscal stability to be at all likely in the coming decades.”
On the positive side for the economy, durable goods orders increased for the third month in a row, rising 1.3% in December. Industrial production rose 0.6% in December, the third monthly increase in a row, and factory capacity utilization rose to 80.7%, the highest in five years. Rebuilding after the hurricanes and a sharp increase in natural gas production helped increase factory output. Consumer spending rose 0.9% in December. The employment numbers released on Friday February 3 showed that non-farm payrolls rose 193,000 in January (with upward revisions for December and November), and the unemployment rate fell to 4.7%. Workers hourly earnings rose 0.4%, a level that was higher than expectations. The market is so data-sensitive right now that the employment numbers led to volatility in the bond market on the day of the release, with a strong sell-off in the yield curve followed by a sharp rally.
Ben Bernanke inherits some very big shoes from Alan Greenspan. As Nobel Laureate Milton Friedman says, Greenspan’s “performance has indeed been remarkable.” The Wall Street Journal proclaims that “his economic legacy seems secure,” and the Financial Times says that “any provisional assessment [of his tenure] must be highly favorable.” Not everyone is lining up to praise Greenspan, however. The Economist said, “On Mr. Greenspan’s watch, America has also experienced the biggest stock market and housing bubbles in history. Presiding over one bubble could be seen as bad luck; presiding over two smacks of carelessness.” None other than Greenspan’s predecessor, Paul Volcker, pointed out that the low volatility in the US hides something more troublesome. “Under the placid surface, there are disturbing trends: huge imbalances, disequilibria, risks—call them what you will. Altogether the circumstances seem to me as dangerous and intractable as any I can remember, and I can remember quite a lot....What holds it all together is a massive and growing flow of capital from abroad, running to more than $2 billion every working day, and growing.” Indeed, this is the economic situation that Ben Bernanke is inheriting from Alan Greenspan: A late stage growth economy coming out of an ultra-low interest rate environment, a debt bubble in mortgage finance that has driven a “frothy” housing market, an increasingly indebted consumer who spends more than he makes, structural imbalances in the current account and Federal budget (which, while arguably not the province of the Fed, were in part created from Greenspan’s tacit approval of tax cuts), dangerously reduced risk premiums across virtually every asset class, a US dollar with reduced purchasing power versus gold and the world’s major currencies, and rising market competition from China and India. We wish the new Chairman the best of luck.
Mr. Greenspan’s legacy will be decided in the fullness of time. In the meantime, we know that most market participants today have probably spent their entire careers with only Mr. Greenspan at the helm. Ben Bernanke, while well-respected as an economist, is a clean slate as a decision-maker. That alone brings more uncertainty into the market. As the Bernanke era begins, we will focus on the data as he would—and there is quite a bit of data due out between now and the next FOMC meeting on March 28—and we wait to hear from him when he delivers the semi-annual testimony on monetary policy to Congress on February 15. As of today, the Federal Funds futures market is pricing in a 90% chance of a 25 bp tightening on March 28.The Markets
Stocks had a very volatile January in the US as the markets assessed the likelihood of future Fed increases. Japanese stocks also bounced around as the markets digested the Livedoor disaster. Short-term and long-term rates were flat throughout the month, only to sell off dramatically at month’s end. Gold and oil finished the month strong, reflecting fears related to Iran’s nuclear ambitions, uncertainty in Israel after Ariel Sharon’s career-ending health problems, the election victory by Hamas in Palestine, and renewed threats from Muslim extremists in Europe.
31-Jan-06 |
31-Dec-05 |
31-Jan-05 |
MOM % change |
YOY % change |
|
Federal Funds Rate |
4.50% |
4.25% |
2.25% |
5.9% |
100.0% |
2-year US Treasury |
4.520% |
4.404% |
3.276% |
2.6% |
38.0% |
10-year US Treasury |
4.517% |
4.393% |
4.130% |
2.8% |
9.4% |
10-year JGB |
1.570% |
1.480% |
1.330% |
6.1% |
18.0% |
10-year euro |
3.468% |
3.309% |
3.542% |
4.8% |
-2.1% |
10-year UK Gilt |
4.150% |
4.100% |
4.606% |
1.2% |
-9.9% |
10-year Canadian govts |
4.166% |
3.979% |
4.212% |
4.7% |
-1.1% |
30 yr conventional mortgage |
6.09% |
6.06% |
5.45% |
0.5% |
11.7% |
Dollar Index |
88.96 |
91.07 |
83.57 |
-2.3% |
6.4% |
Japanese Yen |
117.20 |
117.75 |
103.70 |
-0.5% |
13.0% |
S&P 500 |
1280.08 |
1248.29 |
1181.27 |
2.5% |
8.4% |
Nasdaq Composite |
2305.82 |
2205.32 |
2062.41 |
4.6% |
11.8% |
Gold $/oz (nearby contract) |
$570.80 |
$518.90 |
$421.80 |
10.0% |
35.3% |
Oil $/bbl (nearby contract) |
$67.92 |
$61.04 |
$48.20 |
11.3% |
40.9% |
MBA Refi Index (month-end value) |
1747.2 |
1363.2 |
1932.8 |
28.2% |
-9.6% |
Source: Bloomberg
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. ©2006 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.