Annaly/FIDAC Monthly Market Commentary: April 2006
(posted 5/9/06)

FOCUS

• The Mortgage Market: Prepays tick up due to seasonal factors; cash-out refinancing continues but the economics are changing
• The Economy: The economy strengthens with signs of continuing housing weakness; the market tries to understand the difference between "transparent" and "guidance"
• The Markets: Long-term yields, gold and oil rise, the dollar falls

The Mortgage Market

Mortgage prepayment speeds in March (April reporting period), were mostly in line with market expectations, increasing about 20% due to seasonal factors and an increase in day count.  The Mortgage Bankers Association Weekly Survey of Mortgage Applications for the week ending April 28 showed that mortgage demand was down on a year-to-date basis, pointing towards a slowing trend in the housing market: The Market Index, which measures all mortgage loan application volume, is down 16.4%, the Purchase Index is down 10.2% and the Refi Index is down 24%.  Looking forward most dealers are expecting prepayment speeds to be unchanged or slightly lower in April because of fewer day counts and higher rates. (March had 23 business days, while April only had 19 business days.)  Once again we will be paying careful attention to this developing theme going forward as prepayment speeds have an effect on spreads and performance.

Mortgage refinancers benefit in multiple ways, including a new mortgage with a lower rate and extra cash to spend as they wish.  According to the Freddie Mac quarterly refinance review released on May 2 nd, 88% of Freddie Mac-owned loans that were refinanced in the first quarter of 2006 were at least five percent higher than the original mortgage balance, thus borrowers were taking the opportunity to increase the size of their loan. The $60 billion increase in loan size, or the cash out, is the third highest quarterly amount ever and is the highest level since the third quarter of 1990.  In today’s higher rate environment, however, many fewer are refinancing to reduce their interest rate.  

Interest rates on all mortgages increased between 0.20% and 0.25% in the first quarter of 2006, according to Frank Nothaft, Freddie Mac vice president and chief economist, and for the first time in 20 quarters more than half of refinancers were taking out new mortgages at a rate that was higher than their old rate. Why would they do that? First, they may be approaching the reset date on their adjustable-rate mortgage and may look to refinance into a new adjustable rate mortgage or lock into a fixed rate.  Second, the interest rate on the cash-out refinancing is usually, but not always, lower than the interest rate on a home equity loan. Third, the homeowner may simply be motivated by the desire to extract the equity out of the home and use their house as a source of cash flow, not as a coupon reducing exercise.  Although it is hard to tell what is motivating the homeowner to refinance at this point, what we do know is that they are generally taking on a higher interest rate to accomplish their goal.  

The Economy

“April is the cruellest month.” Although T.S. Eliot had other things on his mind when he wrote those words (more on that later), they are certainly applicable for what the markets have observed over the last month. Every day, gold seems to set highs not seen since the days of Paul Volcker, oil prices have found a new level above $70 a barrel, Iran is behaving like a petulant child, and government bonds around the world have just suffered through their worst two-month period since the markets first began anticipating the Fed would start raising rates in April and May 2004. In Germany, bunds rose above 4% for the first time in a year and half, 10-year JGBs touched 2% and the US 10-year Treasury vaulted above 5%. Two-thirds of all local government bond markets are posting negative returns year-to-date. China raised its benchmark one-year rate 27 basis points to 5.85% in an effort to “fine-tune” an economy that grew at a frenetic annual rate of more than 10% in the first quarter, saw its money supply grow 19% year over year and fostered fixed asset investment growth in Chinese cities of almost 30%. The “conundrum” of unbudging long-term yields in the face of an aggressive front end move is ending as uncertainty comes back into the market place. The risk premium that had been wrung out of financial assets by a Fed that was all too happy to telegraph its next move is coming back because the Fed can no longer do that.

Clearly, the days of predicting the future of Fed policy with certainty are drawing to a close. Much of the market discussion—and volatility—over the month of April revolved around what the Fed’s intentions may be after the May 10 FOMC meeting (the outcome of that meeting is widely expected to be no different than the 15 preceding ones). The hullabaloo began with the relatively strong non-farm payrolls and unemployment rate released on April 7. The market, particularly the July Fed Funds futures contract that is closely associated with the Fed Funds rate after the June 29 FOMC meeting, sold off as the expectations began to build for a continuation of Fed policy. On Good Friday April 14, a day when much of Wall Street was closed, the Wall Street Journal printed a front page story designed to puncture those expectations. The headline read: “As Markets Bet on Rate Increases, Fed Officials Seem Less Committed.” The market eased off. On April 18, the minutes to the March 27-28 FOMC meeting were released, and the following line added to the dovish talk: “Most members thought that the end of the tightening process was likely to be near, and some expressed concerns about the dangers of tightening too much, given the lags in the effects of policy.” The market eased off more. Strong economic data were released over the next few days, including relatively strong existing and new home sales numbers. The market raised the odds of a June 29 raise by 25 bps. Chairman Bernanke himself turned the discussion in his prepared remarks to the Joint Economic Committee of Congress on April 27. “The FOMC will continue to monitor the incoming data closely to assess the prospects for both growth and inflation. In particular, even if in the Committee’s judgment the risks to its objectives are not entirely balanced, at some point in the future the Committee may decide to take no action at one or more meetings in the interest of allowing more time to receive information relevant to the outlook.” After that testimony, the Fed Funds futures market had downgraded the odds of a 25 bp hike at the June 29 meeting to just above 20%, down from over 60% just a week or so before. And then Bernanke lets slip to a reporter that perhaps the market misinterpreted him, which led to a sell-off. All in all, it was a very skittish month, as illustrated by the graph below prepared by Bianco Research.

So where do we stand today? The economy in the US has shown some vigor in the last month. The US Bureau of Economic Analysis released its estimate for first quarter GDP growth of 4.8% on an annualized basis, a significant rebound from the fourth quarter. Durable goods orders were strong and personal spending increased 5.5%, up from 0.9% in the fourth quarter. The latest ISM surveys of manufacturing and non-manufacturing sectors showed strength. The core CPI data for March rose 0.3% for the month and 2.1% year-over-year, as market participants strive to see if there is any pass-through of soaring commodity prices into core inflation. The Fed’s Beige Book, which presents a summary of economic activity on a region by region basis, reported that economic activity was healthy and that “[a] majority of districts note that labor markets, at least for skilled workers, are tight or tightening.” Existing and new home sales data were surprisingly strong after several months of declines.

Many commentators view this set of data points as evidence of a first quarter economy that rebounded strongly from an anomalously weak fourth quarter and that will likely moderate going forward. The relatively weak non-farm payrolls number released on May 5, which reported a less-than expected 138,000 jobs added in the month, supports that notion. And while the latest set of housing sales data were strong, we note that the number of houses for sale in each of the existing and new homes categories, continues to rise. Companies in the US that engage in the business of building new homes, including such industry leaders as Centex, Pulte, KB Homes, and Hovnanian, almost without exception reported order declines and rising order cancellations, and have lowered earnings forecasts. Also, while still historically low, the latest data on home foreclosures and mortgage delinquencies show an increase in levels. One of the reasons cited for this increase is the slowing pace of home-price gains. Fed Governor Donald Kohn, an influential thinker at the Fed, articulated the concern over the housing market in a speech on April 13: “With [housing] demand slowing, house prices also seem likely to decelerate….As a consequence, spending for new housing construction, after contributing nearly ½ percentage point to overall GDP growth last year, may not increase much this year. Moreover, the slowdown in house price increases could well hold back growth in consumption spending on a wide variety of goods and services.”

Our takeaway on all of this data and discussion is that the Fed is still being transparent, but it is no longer in a position to offer the type of guidance about its future policy decisions to which the market has become accustomed. The collection of Fed speeches and texts over the last month seems to suggest that the Fed is prepared for any outcome, and that the market should behave accordingly. The shorthand way to express this is to say that the Fed is “data dependent.” This is a rather meaningless statement, as the Fed has always been “data dependent” in formulating policy, but now the data will be leading policy rather than following. Having already raised 15 times (soon to be 16), the Fed is at the point where it wants to see the effects of its two-year mission to bring the Funds rate from an emergency low level to neutrality.

Last, when Eliot led off his epic poem “The Wasteland” with the line quoted above, he was talking about April as the inflection point between winter, which “kept us warm, covering Earth in forgetful snow,” and spring and summer, which “surprised us” when the rains came and stirred the roots and “mixed memory and desire.” To extend the literary metaphor, the relative certainty of Fed policy over the extended winter of this tightening phase of the cycle has made the market forgetful about the risks of uncertainty. When we look back at April 2006, will we also see it as the point when we return to a market environment that is susceptible to surprise and volatility, when the rain of uncertainty reminds us that interest rates indeed run in cycles? Will the wasteland that is the front end of the yield curve finally revive? Even though we as managers must be prepared for the alternative outcome, we think the Fed is almost there and that it is likely that by the June 28-29 FOMC meeting the Fed will have sufficient evidence of economic weakness to warrant a pause in its tightening regime.

The Markets

Long rates around the world were up in April, perhaps reflecting the same pressures driving up the gold price. Not surprisingly, the US dollar weakened against most currencies. US stocks, lagging the rest of the world, barely moved. Mortgage rates rose again.

Source: Bloomberg; Japanese Yen quote is the London feed

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