The Economy
It was approximately a year ago that the Federal Reserve lowered the Funds rate to 1%. Since then, it has vigorously assured the market that it would do everything in its power to keep the economic recovery alive, stave off deflation and shore up slack resource usage. Worried that these problems were intractable and eager to telegraph its intentions, the Fed began saying in August 2003 that it would maintain its accommodative stance for "a considerable period." In January 2004, to signal that it would not be complacent in changing its stance if conditions changed, the Fed changed the wording in its policy statement: "[T]he Committee believes that it can be patient in removing its policy accommodation." Duly warned by this subtle shift in message, the market then watched and waited for the next signal, either from the economic statistics or the Fed itself, that a change in policy stance was coming.

The first well-defined signal came on April 2, with the release of surprisingly strong non-farm payroll numbers (since revised upward to +353,000 jobs). The market began a significant sell-off in anticipation of a Fed move. The second well-defined signal came from the Fed itself. With evidence accumulating that its efforts were bearing fruit, in its May 4 FOMC statement the Fed announced that the risks to price stability and the risks to economic growth were in balance. "[W]ith inflation low and resource use slack," the statement intoned, "the Committee believes that policy accommodation can be removed at a pace that is likely to be measured." The strong non-farm numbers released on May 7 and June 4 have confirmed the trend in job growth. An upturn in capacity utilization and industrial production has followed. Business inventories have been building and corporate profits continue to grow. Signs of pricing pressure, while still mixed, have begun to be noticed in the official government statistics. (New York City residents already noticed prices rising: Taxi fares are up 26%, and rising milk costs have prompted some pizzerias to raise the price of a slice.) The producer-price index for April rose 0.7%, with the core up 0.2%. The CPI ex-food and energy was up 1.8% year over year in April, a big reversal from the 1.1% lows at the end of 2003.

As far as the market is concerned, it is almost certain that the Fed will raise the Fed Funds rate to 1.25% at its June 30 meeting. In fact, based on the movement in the yield curve since April 2, it is fair to say that the market has already tightened and is now waiting for the Fed to ratify its conclusion. In other words, as usual, the market leads the Fed. The graph below shows the Fed Funds futures contract strip on March 31 and June 4. What this graph tells us is that on March 31 the market was looking for about 25 bp of tightening by the end of 2004. Since the beginning of May, however, the market has been pricing in 25 bp at the June 30 meeting. In fact, the market is currently predicting at least a 2% Fed Funds rate by the end of 2004.

As far as the market is concerned, it is almost certain that the Fed will raise the Fed Funds rate to 1.25% at its June 30 meeting. In fact, based on the movement in the yield curve since April 2, it is fair to say that the market has already tightened and is now waiting for the Fed to ratify its conclusion. In other words, as usual, the market leads the Fed. The graph below shows the Fed Funds futures contract strip on March 31 and June 4. What this graph tells us is that on March 31 the market was looking for about 25 bp of tightening by the end of 2004. Since the beginning of May, however, the market has been pricing in 25 bp at the June 30 meeting. In fact, the market is currently predicting at least a 2% Fed Funds rate by the end of 2004.

The market may be wrong again. The market may be right. We will all know more in the fullness time. As far as we are concerned, however, there is only one certainty, and it is this: In our experience, we have seen that the Greenspan Fed does not act impulsively. The Fed has also learned from 1994's violent sell-off that it should not spook the bond market. Leverage in the financial system-federal, municipal, corporate, individual-as well as the potential for missteps by highly leveraged institutional investors who have been enjoying the lucrative carry trade provide additional arguments for a "measured" response to this tightening cycle. We don't believe that the Fed has made a decision to raise rates lockstep to 2% by year end. It is far more likely that the Fed will examine each new release of economic data and make a decision at each FOMC meeting in light of where we've come, the state of the financial markets, events in the country, economic conditions around the world and other geopolitical wild cards. For us, we believe that with job growth seemingly in hand, the Fed will be most concerned about inflation data.

There is one more thing of which we are certain: Markets will remain volatile. Over the last quarter, equity markets have lacked direction and fixed income strategies have struggled. In the US and around the world, major stock indexes are down for the last three months. Over the same period, the 2-year, 5-year and 10-year Treasuries have generated total returns of -1.29%, -3.79% and -5.59%, respectively; the Lehman Aggregate, Agency and High Yield have total returns of -2.99%, -3.02% and -1.89%, respectively. We have managed our portfolios accordingly, by keeping asset duration short and leverage low to minimize declines in net asset value. By maintaining low leverage, we also make it possible to take advantage of market inefficiencies and attractive asset purchases when the opportunities present themselves. At the same time, the current steepness of the yield curve has enabled us to still earn rich yields for investors from the spread between the yield on assets and the cost of funds.

With this backdrop, we would like to reiterate a few salient points about our strategy when the Fed Funds rate is rising. A first order effect will be, of course, for our cost of financing to increase and for the coupons on our CMO floaters to reset upwards by approximately the size of the move, thereby capturing spread. Our ARMs will reset over time. The second order effect will be for all of our assets-floating rate, adjustable rate and fixed rate-to experience a rise in yields as prepayments slow and the currently high levels of amortization expense begin to subside. We should begin to see this effect begin in June and continue throughout the summer. The rise in spread serves to offset any decline in asset value. As rates move up, the fully paid or unlevered portion of the portfolio earns more. As well, mortgage-backed securities are amortizing assets, a characteristic which works in our favor in a rising rate environment. Unlike other investment strategies, we are able to reinvest principal and interest we receive every month into the new, higher yielding environment, without selling assets (which would realize mark-to-market losses) or raising new capital.

The Mortgage Market
As the 10-year Treasury bond yield rose by 0.15% during the month of May, the slowdown expectations for mortgage prepayments are likely to come to fruition over the next few months. This is evidenced by the rise in Freddie Mac's Primary Mortgage Market survey rate by 0.31% to 6.32% for the month of May and the 37% fall in the MBA Refinancing index, which measures all applications to refinance an existing mortgage loan, from 2516 at the end of April to a 2-year low of 1584. With rising mortgage rates, the incentive to refinance a mortgage loan should fall. For instance, a rise in the mortgage rate from 5.75% to 6.50% on a $175,000 30-year loan would increase a borrower's monthly payments by about $85 or 8.3%. From this simple example, one can see one reason why most of Wall Street expects prepayments for the second half of the quarter to slow considerably from the recent peak speeds reached in March and April. Slower prepayments will likely result in a decrease in amortization for the summer months.

MBS slightly outperformed Treasuries for the month of May as investors anticipated slower prepayments and muted supply. Although slowing, the market continues to see demand from banks for mortgage product as commercial and industrial loan growth has been very modest. JP Morgan research estimates that over 40% of bank assets were in MBS and other real estate related investments at the end of April. However, the prospect of a Fed tightening raises concerns that banks may temper their demand for mortgage product, resulting in near term pressure on mortgage spreads. We expect this widening to provide opportunities to add exposure at more attractive levels.

The Markets
In May, the bond market continued its sell-off in anticipation of a Fed move at the end of June. Yields across the curve were higher, although the change was more moderate compared to the change in April. Stocks were up slightly, as investors were apprehensive in the face of higher interest rates. The dollar weakened slightly, gold traded in a range. In the oil market, increasing global demand, headlines on future dwindling secular supply curves and tensions in the Mid-East have driven prices to even higher levels.