The Economy
"It was the best of times, it was the worst of times." The paradoxical US economy indeed brings Dickens to mind: America has a strengthening economy with erratic job growth, very high commodity prices with virtually no measurable consumer inflation, ultra- low interest rates with weak bank lending, a weakening currency with little visible interest rate pressure. What's a central bank to do? In a decision that was not unexpected, the Federal Reserve did nothing, holding rates steady at 1% at the March 16th meeting of the FOMC. Of greater import to the market was the manner in which the news was delivered. In its statement, the Fed repeated that it would be "patient in removing its policy accommodations," but the rest of the statement contained subtle yet significant changes. Whereas the January 28th statement said, "Although new hiring remains subdued, other indicators suggest an improvement in the labor market," in the March 16th statement the Fed was forthright on job creation. "Although job losses have slowed," the latest statement read, "new hiring has lagged." The singling out of employment as an economic indicator is significant, for the pace of employment growth has been uncomfortably low for what is supposed to be an economic recovery. The minutes to the FOMC's January 27-28th meeting reflect confirmation of strength in a variety of economic conditions. The minutes show committee members discussed that "the information that had become available since the December meeting had tended to validate their earlier assessment that the expansion was firmly established and that robust economic growth, under way since about mid 2003, was likely to continue as the year progressed." Specifically, the members cited strong business expenditures, productivity gains, rising business confidence, increasing corporate profitability, the potential for inventory building and the strength of the household sector, which was "continuing to supply major impetus to the expansion."

Since then, economic data has continued mostly positive. US industrial production rose by 0.7% in February, beating expectations, and capacity utilization increased half a percentage point to 76.6%, the highest in 20 months (but still below levels of the last two recessions). Durable goods orders rose 2.5% in February, also beating expectations, thanks to aircraft and motor vehicle orders. The US Commerce Department announced that corporate profits had risen by the fastest pace in almost 20 years in the fourth quarter, largely from productivity gains and low borrowing costs. In the quarter, corporate pre-tax profits rose 29% from the prior comparable quarter. The nonfarm payroll number released on April 2 notwithstanding, job growth has been weak. It has been 28 months since the end of the recession in the United States (official end date: November 2001). Summing up the changes in nonfarm payrolls since then, the US has lost a total of 111,000 jobs. As the graph shows, there have been 10 other recessions since the end of World War II, and the average total number of new jobs created in the first 28 months after the end of a recession has been 4.1 million.

Clearly, there is something unique about the American recovery in this economic cycle. The employment number released on Friday April 2 exceeded expectations and the bond market sold off as a result. We would argue that expectations had been managed to a low level. Consider that in the 28 months following the end of a recession, the average monthly gain in nonfarm jobs has been approximately 148,000. In the current expansion, that average has been a loss of 4,000. The current reading is the highest monthly gain since the end of the recession; after prior recessions, the highest monthly gain would typically come much sooner. We agree with Goldman Sachs chief US economist Bill Dudley that the Fed is not likely to tighten because of this one report. To Dudley, the labor market is still slack, there is no apparent upward pressure on wages and total hours worked actually fell. "[I]t is important to remember," Dudley writes, "that Fed officials look at the data trend mainly over longer intervals--say three months and six months. On this basis, the performance of payrolls is much less impressive." It does, however, make the next report, out on May 7, important to watch to see if there is confirmation that a trend is developing.

Inflation, while still quite low, is showing faint signs of stirring: February CPI was up 0.3%, after rising 0.5% in January (the "core" rate, ex-food and energy, was up 0.2% for the second month in a row); January and February PPI rose 0.6% and 0.1%, respectively; and the price index for personal consumption expenditures, or PCE, increased in the fourth quarter at an annual rate of 1%, and 1.2% ex-food and energy. Economists diverge on the direction of pricing pressures: "So which way will it be for the world economy," asked the Wall Street Journal on March 24, "a long-overdue pickup in inflationary pressures or the dreaded 'D' word, deflation?" The FOMC believes that the risk of inflation and deflation are still about equal. Despite the relatively benign pricing pressures, however, commodity prices are skyrocketing. A combination of supply chain bottlenecks, production capacity shortages, very strong demand from China and the weak dollar have contributed to historically high prices for raw materials. From January 1, 2002 through the end of March 2003, the CRB Futures Price Index, an index of the nearby futures prices of a mix of industrial, agricultural and precious commodities, is up over 50%. The Goldman Sachs Commodity Index, an index of spot prices of a basket of commodities that is more weighted towards the petroleum complex, is up over 70% over the same period. These widely followed indexes are approaching levels not seen since the Great Inflation of the late 1970s, when interest rates were in the double digits. Clearly, something unique is going on in the world of commodities, and not just oil. Yes, oil is approaching $40 a barrel, the highest point since the first Gulf War, but other commodities are also showing extraordinary tightness. Copper is up almost 90% from recent lows, platinum up 100%, and soybeans up 143%. These commodity prices have yet to find their way into prices at the consumer level for two dominant reasons--first, much of the demand that is driving prices is sourced to China, and second, commodity prices are actually a very small part in the cost structure of finished consumer goods. Nevertheless, market participants are uneasy, either that commodity prices trigger inflation in producer and consumer prices, or that higher commodity prices--particularly the price of oil--becomes a drag on the economy.

We also note that the cyclical recovery underway in Japan has prompted Standard & Poor's to upgrade its rating outlook to "stable." In China, the People's Bank of China said it would raise its reserve requirement and its re-discount rate. In Europe, the ECB decided not to reduce its benchmark rates. All of these developments could lead to a continuation of the weakening trend of the US dollar.

The Mortgage Market
The decline in the yield on the 10-year Treasury and the associated fall in mortgage rates in the first quarter of 2004 have led to a virtual doubling in the pace of refinancing activity in the US. From January 1, 2004 to March 31, 2004, the 10-year yield has fallen from 4.247% to 3.837%, and the Fannie Mae Commitment Rate on 30-year mortgages has fallen from 5.59% to 5.29%. At the same time, according to BanxQuote, the average rate on a conforming 30-year mortgage has fallen from 5.78% to 5.52%. The MBA Refinance Index, which measures applications for refinancing a residential mortgage, has soared from 1644.3 on 12/26/04 to 4857.6 on 3/26/04. The recent increase in the Refi Index has prompted Wall Street to ratchet up estimates for prepayment speeds.

The mortgage research team at Bear Stearns estimates that if the 10-year yield falls to 3.5%, the Refi Index would approach 7200. Beyond that, they say, "[B]ecause of the redistribution of mortgage coupons that took place last year (the 5.5% coupon now makes up almost 35% of the mortgage universe followed by the 5.0% coupon at 21% of the universe) mortgage rates would have to fall below 5.0% before the risk profile of the 2003 scenario is replicated." Even at these levels, says UBS strategist Laurie Goodman, "We don't expect speeds to come close to those in mid-2003...And even at similar rates and rate attractiveness, the fact that we are merely retracing old lows implies weaker refinance responses."

Even with the recent pick-up in refinancing activity, the fundamentals in the mortgage market have improved dramatically since mid- 2003. In our portfolio, this can be traced by reviewing the monthly return results, the declining CPR and the improving spread since then. Given the recent move in the market we are doing what we do every day: we review the portfolio in light of current conditions, in this case evaluating in anticipation of faster prepays. There is no target formula for the portfolio composition. We look at all of the variables we typically review in our scenario analysis: potential mark to market moves, duration shifts, reinvestment of expected cash flows, leverage levels and return expectations. If as a result of this analysis we determine that we need to rebalance the portfolio in order to meet our return objectives, we will. While the pickup in the MBA Refi Index will likely lead to an increase in amortization in the coming months, the effects of the move to date will not be as dramatic as it was last summer and fall.

The first hurdle on the way to a new regulatory structure for the GSEs was cleared on April 1, when the Senate Banking Committee approved legislation that is similar in basic structure to what we outlined in our last commentary. There is still a long way to go, however, before we see any laws passed, because there are still considerable partisan differences. One of those key points of contention, the power of receivership, would give the new regulator the ability to dissolve an insolvent agency; currently the regulator has the power to run the agencies in the event of trouble, but it can't shut them down. In short, the Republicans want to give regulator receivership powers, while the Democrats want to leave it with Congress.

How should the rating agencies and the market view the relationship between the Federal Government and Fannie and Freddie after the new regulatory regime is in place? We don't know what it would take to change the market perception of implied government backing. The elements that support that belief are primarily the $2.25 billion credit arrangement that each agency has with Treasury, the government charter, the disclosure and tax exemptions, the board of directors appointments, the inclusion of Agency data with reports from Treasury and the Fed, etc. Most importantly, the belief is based on the sheer size of the GSEs in the bond market and as a source of and agent for mortgage capital, the primacy of their nominal charter to the American Dream and the fact that the smoothly functioning mortgage finance system has been a powerful economic driver.

All of the ratings agencies consider the government charter and GSE status central to their ratings assessments. What would it take to cause a ratings change? A removal of the credit line? Granting receivership powers? Both? Moody's said in a March 2004 special comment: "The proposed legislation holds no ratings implication for Fannie Mae, Freddie Mac or the FHLBanks....The inclusion of receivership language in the bill is not a rating concern. We also do not view its inclusion to mean the US Government-implied support for these GSEs would be diminished." In fact, the Senate Banking Committee approved a compromise of sorts, in which the new regulator has power of receivership, but gives Congress 45 days to reverse the decision.

The last WHAT IF of all of this is what the market reaction would be to these proposed changes. We think it is just impossible to predict if there would be a market reaction and, if so, what it would be. One indication, however, is the fact that even with all of the headline risk and range of possible outcomes, Agency paper is trading as tight as ever.

The Markets
In March, the bond market rallied mid-month, but backed up as the month drew to a close. Stocks were mixed, gold rose and oil held at high levels. The yen strengthened versus the dollar.