Annaly/FIDAC Monthly Market Commentary: February 2006
(posted 3/15/06)

FOCUS

• The Economy: Ben Bernanke has his debut; assessing the principal risk to the economy
• The Mortgage Market:Prepays slow, but may pick up going forward; the Rudman report offers nothing new
• The Markets : Global interest rates rise; US stocks fall

The Economy

In his debut before Congress as Chairman of the Federal Reserve, Ben S. Bernanke managed the difficult trick of displaying intellectual and stylistic independence while not alarming the market that he was going to veer from the course set by his predecessor. He was succinct, clear and authoritative (a departure from Greenspan’s style), but also sufficiently equivocal about what he thought about the future. “Although the outlook contains significant uncertainties,” he said in the semiannual monetary policy report to Congress, “it is clear that substantial progress has been made in removing monetary policy accommodation. As a consequence, in coming quarters the FOMC will have to make ongoing, provisional judgments about the risks to both inflation and growth, and monetary policy actions will be increasingly dependent on incoming data.”

As it relates to the utility of relying on “incoming data” for direction on monetary policy, Chairman Bernanke finished his testimony before Congress by noting the inherent uncertainty of relying on economic models and the data that drive them. “[A]ny model is by necessity a simplification of the real world, and sufficient data are seldom available to measure even the basic relationships with precision.” He concluded by saying that the best a central banker can hope to do is “formulate a view of the most likely course of the economy under a given policy approach while giving due weight to the potential risks and associated costs to the economy should those judgments turn out to be wrong.”

We couldn’t agree more, but that bit of candor notwithstanding the assignment before our office and our investors is to try and review the data from the perspective of the Fed in order to “formulate a view” on the future direction of interest rates. And as far as that goes, we have no crystal ball. We are no more clairvoyant than the market, and the market seems virtually unanimous that the Fed will be raising the Fed Funds rate for the 15 th straight FOMC meeting on March 28. As Chicago-based Bianco Research has pointed out, since the Fed began to provide more transparency in its statements in 2003, the Federal Funds futures market has accurately predicted the outcome of the meeting 100% of the time within a 35 day horizon. Who are we to argue with such certainty? Thus, absent huge surprises to the downside between now and then, it is highly likely that on March 28 at 2:15 pm EST the Fed Funds rate will stand at 4.75%. Indeed, the market has virtually priced in this eventuality, with the 2-year Treasury currently standing at 4.76%.

The Fed Funds futures market gets less accurate the further away the FOMC meeting is. Moreover, given the uncertainty professed by Chairman Bernanke, the March 28 statement may not contain such forward-looking statements as “measured” and “patient.” Thus, we need to look ahead to the May 10 meeting, which would likely be the first meeting that would see a cessation of the tightenings. The data are sufficiently mixed so as to render the forecast up for debate. On the one hand, certain data point to a healthily growing economy. At last reading capacity utilization was 80.9%, down slightly from December’s reading of 81.2%, the highest since September 2000, due to reduced utility activity related to the warm month. The unemployment rate was 4.7%, the lowest in more than 4 years. Oil prices remained at elevated levels. The trade and current account deficits continue unabated. Central banks around the world—including Japan—are hawkish, a fact that is also having a bearish effect on the long end of the yield curve.

On the other hand, there are some signs that pressure on prices is relatively light and that there are threats to growth. The inflation data out in February was universally benign, with core CPI up 0.2% in January and 2.1% year-over-year. Core PPI was up 0.4% in January and 1.5% year-over-year. And core PCE, the Fed’s favorite inflation barometer, was up 0.2% in January and 1.8% year-over-year. Despite these data, all of the recent releases out of the Fed—the Jan. 31 FOMC statement, the Feb. 15 semiannual report and the minutes to the FOMC meeting released on Feb. 21—indicated that there is still concern about inflation, about tightness in resource utilization, about the potential for higher oil prices to start working through to the economy. As the minutes said: “Although the stance of policy seemed close to where it need to be given the current outlook, some further policy firming might be needed to keep inflation pressures contained….” To date, though, inflation seems to be well-contained.

The minutes and Chairman Bernanke’s testimony devoted a considerable amount of attention to the biggest threat to growth in the economy—the housing market and the consumer. In the minutes, participants noted that consumption in the fourth quarter was “likely supported by further gains in home values and equity prices that raised the ratio of household wealth to disposable income….” Later, participants noted that in some areas “home price appreciation had slowed noticeably, highlighted the risks to aggregate demand of a pullback in the housing sector. For instance, the effects of a leveling out of housing wealth on the saving rate were…potentially sizable. Rising debt service costs, owing in part to the repricing of variable-rate mortgages, were also mentioned as possibly restraining the discretionary spending of consumers.”

There are increasing signs that the housing market is cooling. New home inventories and existing home inventories are up significantly year-over-year, 21% and 36% respectively, and the months of supply at the current pace of sales is also at new cyclical highs—5.2 months for new homes and 5.3 months for existing homes. The pending sales of new homes has been declining since August. As one might expect to see at a time when supply is increasing and demand is falling, price appreciation is moderating. The median sales prices of new and existing homes have fallen from their summertime peaks. In fact, for the first time in over four years, the median new home sales price in December was below its year-earlier levels. According to Merrill Lynch, a slowdown in the housing market that reduces the rate of mortgage equity withdrawal poses “the single largest downside risk” to its future economic outlook.

Economists agree that housing today plays a much larger role in consumer spending than it did in the 1980s. It is likely playing the same role in this expansion that the Tech boom in the stock market did in driving the economy of the late 1990s. Mortgage equity withdrawals, estimated at approximately $700 billion, likely accounted for 7% to 8% of disposable after-tax income last year. In 1989, that equity extraction totaled just $82 billion, or 2% of DPI. Merrill Lynch estimates that over 60% of the growth in consumer spending in 2005 can be attributed to home equity cash-outs. This type of activity can only happen if home prices appreciate. They don’t have to even fall, they just have to stop going up. As Paul Kasriel, chief economist at Northern Trust puts it, “If house prices were to level off, consumer spending would be adversely affected because the “home ATM” would not be refilling. If house prices were to fall—well, I don’t even want to think what would happen to consumer spending. A slowdown in consumer spending emanating from a busted housing market would lead to an increase in unemployment, which would have further knock-on effects…to consumer spending and unemployment.” Chairman Bernanke, please take note.

The Mortgage Market

Mortgage prepayment speeds in January (February reporting period) declined by over 20%. With the 10% decline we had in December and the 15% decline we experienced in November, it makes it the third month in a row of slowing prepayment activity. According to Citigroup research, January is typically the trough for the seasonal cycle of home sales. Further, the holiday slowdown in December for refinancing activity also contributes to much slower speeds during the January period. Thus, after several months of declines in mortgage prepayment speeds, the dealer community is now expecting speeds to pick up in the coming months as the slower seasonal factors of the winter months begin to wane and refinancing activity picks up.  Specifically, Wall Street forecasts are calling for a 5% to 10% increase in February prepayments followed by a larger jump in March. The expected prepayment speed uptick in March is not unwarranted as we experienced similar seasonal speed increases for the March period in 2005 and 2004. However, it remains to be seen how refinancing activity in the coming months will be affected by the recent sell-off in 10-year Treasury yields to over 4.7%.

The Markets

Stocks were flat to down in February as the prospects of higher long-term and short-term rates began to weigh on sentiment. Gold and oil eased but remain at elevated levels. Japanese bonds feel the pressure from a vocal Bank of Japan. The MBA Refi Index fell again.

Source: Bloomberg; Japanese Yen quote is the London feed

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