Annaly/FIDAC Monthly Market Commentary: March 2006
(posted 4/10/06)

FOCUS

• The Mortgage Market: Prepays pick up speed, and are projected to increase further due to seasonal factors
• The Economy: The Fed raises for a 15 th time; Ben Bernanke leaves us guessing; watch out for housing
• The Markets : Gold, oil, stocks and rates all rise

The Mortgage Market

Mortgage prepayment speeds in February (March reporting period) increased by about 5%, ending the seasonal decline we experienced the prior three months. As we mentioned last month, January is typically the trough for the seasonal cycle of home sales. Thus, a pickup in speeds is typical as we enter the spring months. Dealer forecasts are looking for March speeds to increase by 20% over February levels. The next few months of speeds will be an important leading indicator to how much the housing market is slowing from the boom years of 2004 and 2005. As of now the MBA Refinancing Index is down about 9% year-over-year, pointing towards a slowing trend but not a major drop in activity. We will be paying careful attention to this developing theme going forward as it will certainly have an impact on prepayment speeds and spreads.

We mentioned a few months ago that we expected an increase in the production of “new” fixed-rate affordability mortgage loans as homeowner affordability remained near its lowest point in over 10 years and the yield curve continued to be flat. This has certainly been the case as we have seen the fixed-rate interest-only loan start to make its way into the mainstream of mortgage products. According to UBS research fixed-rate interest-only issuance for 2006 now makes up 7.2% of 30yr Fannie Mae production. In prior years this number would have been close to zero. So what makes this product so attractive to the potential homeowner?  As you will recall, a fixed-rate interest-only loan typically consists of a 30 year amortization period but there is a 10 year term in the beginning whereby the borrower has the option to pay just the interest portion on their loan amount. At the end of 10yrs the borrower then must amortize the principal portion of their loan amount over the remaining 20 years. The interest-only payment option can save a borrower a decent amount of cash from a monthly payment standpoint for the first 10 years, allowing the borrower to afford more house. For example, on a normal 30 year fixed-rate $250,000 loan with an interest rate of 6.5% the monthly payment would be $1,580. If this loan were a fixed-rate interest-only loan the borrower would be charged an extra 0.125% in rate and thus the monthly payment would be $1380, a savings of  $200 a month or $2400 per year relative to a conventional fixed-rate loan.    

The Economy

For any market participant expecting a change in Fed monetary policy with Ben Bernanke now at the helm, we quote that famous economic philosopher, Pete Townshend: “Meet the new boss, same as the old boss.” Indeed, Bernanke’s first turn at the head of the table resulted in the same outcome—a 25 basis point increase, this time to 4.75%—as the prior fourteen FOMC meetings headed by his predecessor. The statement announcing the latest rate hike contained an additional sentence or two related to the economy, but the forward-looking paragraph remained identical to that of the January 31 statement: “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. In any event, the Committee will respond to changes in economic prospects as needed to foster these objectives.” In other words, barring any truly disastrous economic data between now and then, the FOMC will likely raise the Fed Funds rate at its May 10 meeting by another 25 bp to 5.0%. We believe that any change in that meeting’s FOMC statement will be a signal for an end to the tightening.

Anyone expecting anything new from Bernanke should have been sitting next to us at the new Chairman’s first major speaking opportunity since taking office. On March 20, we attended a forum hosted by the Economic Club of New York, at which Bernanke delivered a speech that was directly on point with what concerns us in the markets. Its title: Reflections on the Yield Curve and Monetary Policy . Despite its promising title, the speech, essentially a collection of ideas previously addressed by Bernanke in other venues, broke no new academic or policy ground. Not willing to tip his hand to the market, he presented arguments for why the Fed might have to keep tightening or, alternatively, why it might have to stop tightening. Thus, it is no surprise that the next day the major papers came away with different conclusions about what he meant to say. “Although Mr. Bernanke steered away from any clear signal on the direction of interest rates,” said the Wall Street Journal on March 21, “his speech was notable in that he gave more weight to factors favoring a ‘lower’ neutral funds rate than have some other current and previous Fed officials.” The Financial Times, on the other hand, ran the following headline: “Bernanke sees no sign of slowdown.” The fact that Bernanke could give one speech that led to more than one conclusion about his meaning would have made Alan Greenspan proud.

Despite the ambiguity in Bernanke’s speech, we believe that over time he will do things a little differently than Greenspan. Befitting a professor, he usually wants people to actually understand him when he speaks. This stylistic habit extends to his approach to Fed communication, as he is a strong believer in the power of transparency in telegraphing monetary policy objectives. “Providing information about the expected path of policy,” he said in his speech, “helped to ensure that long-term interest rates and other asset prices did not build in a projected pace of tightening that was more rapid than the Committee itself anticipated, and the statement's focus on the conditionality of future policy actions emphasized the ongoing need for both policymakers and financial market participants to respond to economic news. In retrospect, the clear communication of policy provided notable benefits, in my view, by increasing the effectiveness of monetary policy while minimizing unnecessary volatility in financial markets.” We don’t know if we agree with his conclusion, as perhaps an excess of transparency has been responsible for a reduction in risk premium at the long end of the curve. We attended a speech given by Paul Volcker last week at a conference sponsored by Grant’s Interest Rate Observer in which he suggested that transparency, and inflation targeting, could give the impression that the US economy is simpler than it really is, or that a policy decision can be based on a single number. According to Volcker, a more appropriate approach to central bank communication is to engage in what he called “constructive uncertainty.” The challenge for Bernanke today is how to be transparent about the intent of the Fed during a period in which the direction of monetary policy is unclear. In other words, in a period like we have today.

We also believe that as a former academic Bernanke’s approach to decision-making will be more classical than Greenspan, who sometimes seemed to flout convention in responding to economic statistics. How will Bernanke view the economic story that is being told by the statistics? The new chairman is an internationalist, so we think he will look at data from both inside and outside of America’s borders. Rising short-term rates around the world are having cross-border effects in countries such as Iceland and New Zealand. Japan, in the middle of an economic rebirth, has a change in monetary policy in its future as it reported that its unemployment rate hit its lowest level in almost eight years and the latest Tankan survey showed inflationary pressures are rising. The European Central Bank is in tightening mode. Net purchases of US securities by foreign investors are still strong. Inside the US, inflation data released during the month showed little evidence of pricing pressure on the end purchaser. The ISM manufacturing index shows a decelerating trend through the latest reading. Industrial production and capacity utilization were slightly lower in the month. Perhaps Bernanke also is mindful of the events unfolding in Detroit, as GM and Ford grapple with declining market share, uncompetitive labor costs, falling debt ratings and rising interest rates. It is no longer out of the realm of possibility that these two paragons of American industry may have to consider bankruptcy protection.

As we suggested in last month’s Commentary, we believe that the Fed can’t ignore the weakening of the housing market. We received two seemingly conflicting housing sales numbers in the month, as existing home sales jumped by 5.2% in February while new home sales plunged 10.5% from the prior month. One explanation for this difference is that existing home sales measures transactions that have closed—and therefore would have been helped by unseasonable warm weather in January and February—while new home sales measures transactions that have just filed contracts. Pending existing home sales, which generally foretells future declines in existing home sales, declined in February, the fifth decline in the last six months. New home sales slid to its fourth consecutive monthly decline, and the months of supply of new homes rose to 6.3 months. The market is clearly watching housing data, as the movement in the bond market on March 23—the day of the existing home sales release—and March 24—the day new home sales data are released—reflected the different reactions. The 10-year Treasury yield rose from 4.701% to 4.735% on March 23 on supposed strength of existing home sales, but fell to 4.671% on March 24 on the weak new home sales data.

Several economists have demonstrated that the behavior of new home sales is a powerful leading indicator of GDP growth, and the trend of the last few months is decidedly negative. One of the linkages between the housing market and the overall economy is the ability of homeowners to extract equity from their homes through cash-out mortgage refinancings (the process of refinancing a mortgage with a larger mortgage). As the graph below illustrates, this process has ballooned in the past few years, and has provided a significant underpinning to, among other things, the ability of consumers to consume. Two things will affect the ability of borrowers to continue to extract equity—the level of interest rates and the level of home prices. Mortgage rates are rising; as for the level of home prices, Angelo Mozilo, CEO of Countrywide Financial, the country’s largest mortgage lender by market share, recently said, “I would expect a general decline [in housing prices] of 5% to 10% throughout the country, some areas 20%. And in areas where you have had heavy speculation, you could have 30%.” We think he probably knows a thing or two about the topic.

The Markets

US stocks and commodities were up in March. Long-dated government bonds around the world fell, with the JGB continuing to feel the most selling pressure. Short-rates in the US rose as the Fed raised the Fed Funds rate 25 bp on March 28. Mortgage rates rose again.

Source: Bloomberg; Japanese Yen quote is the London feed

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