Annaly/FIDAC Monthly Market Commentary: May 2006
(posted 6/13/06)

FOCUS

• The Mortgage Market: Prepayments decline; OFHEO reports on Fannie Mae
• The Economy: The Fed faces a dilemma, and will likely react hawkishly
• The Markets: World equity markets react badly to signs the Fed may keep going

The Mortgage Market

Mortgage prepayments, as expected, decreased 16% in April (May reporting period), due to higher interest rates and fewer business days. US mortgage applications declined in May to levels we haven’t seen since May 2002. Higher borrowing costs also helped cause slowdowns in home purchases and refinancing as well. The Mortgage Bankers Association’s Purchase Index and Refinancing Index declined 15% and 34% year-over-year, respectively. Despite higher interest rates, dealers forecast speeds to increase in May because of more business days and a seasonal rise in home sales.

On May 23, 2006 Fannie Mae’s regulator, OFHEO, released its long-anticipated report on the company (see “Note on OFHEO’s Special Examination of Fannie Mae” on our website at www.annaly.com/commentary.html ). It reviews the accounting transgressions and management lapses that were uncovered over the past several years. In conjunction with the report release, Fannie agreed to implement corrective measures and pay a $400 million penalty as part of settlements with OFHEO and the SEC. The other key elements of the settlement require Fannie Mae to undertake comprehensive corporate governance and organizational control reforms, review current and separated employees for possible remedial action, continue to maintain 30% in excess capital and limit growth of its portfolio mortgage assets to the level of December 31, 2005. Subsequently, Freddie Mac said that it expects OFHEO to limit its portfolio growth as well. With this limitation on Fannie Mae we should see more of their supply being offered in the market; however we don’t see the settlements as having a major impact on the MBS market.

The Economy

We feel like we’ve written the following sentence before: As expected, at the latest meeting of the Federal Open Market Committee, the Fed raised the Fed Funds rate another 25 bp. Déjà vu notwithstanding, what was perhaps unexpected in the latest meeting was that the Fed did not offer more guidance on its future course of action. In the weeks leading up to the meeting, the market had been somewhat led to believe that a pause in the tightening was in the offing, and the lack of guidance to that effect set off a firestorm of volatility here and around the world. World equity markets sold off: From May 9 through June 8, the Dow Jones Industrials Index is down 6%, Canada’s TSX Index is down 7%, Australia’s ASX 200 Index is down 8%, the DAX Index is down 10%, the Singapore Straits Times Index is down 13%, the Nikkei 225 is down 15%, and Mexico and Brazil are both down over 15%. India’s Sensex Index is down a massive 26%. Equity investors are spooked by the prospect of future tightenings, not just in the US but also in Europe and Japan, while the bond markets seem to be in a wait and watch mode.

The horns of the economic dilemma—economic growth vs. inflation—are evident in the FOMC statement, the minutes to the meeting (released May 31) and the recent set of speeches out of Fed officials. The textbooks would tell you that they go together, that the monetary conditions that are promoting growth also put upward pressure on prices. The classical central banking response is to slow down the economy by tightening the very same monetary conditions (i.e., through raising the Fed Funds rate or draining liquidity), thereby snuffing out inflation. Sometimes, however, growth and inflation don’t go hand in hand. The productivity “miracle” of the 1990s resulted in growth without inflation, while the stagflation of the 1970s saw inflation without growth. The fear in the market today is a replay of the stagflation scare of a generation ago. As Ben Bernanke stated in a speech this week, “Our economy has reaped ample rewards in recent years from the achievement and maintenance of price stability. Although challenges confront us, as they always do, I am confident that we will be able to preserve those hard-won benefits while promoting sustainable economic growth.”

It remains to be seen whether Chairman Bernanke can succeed with the tools at his disposal. Most of the economic data released this month have been relatively weak: While the US economy grew at 5.3% in the first quarter, most economists expect slower growth in the second quarter. Both ISM manufacturing and non-manufacturing indexes declined, factory orders fell and durable goods orders fell. Consumer confidence is slipping as sentiment and behavior is beginning to be influenced by higher oil and gas prices. Industrial production and capacity utilization data are marginally stronger, but in a way that is consistent with late cycle performance. All of the housing data—pending home sales, housing starts, building permits, new and existing home sales, inventories of unsold homes—came in weaker than the prior month. And the non-farm payrolls report was below expectations for the second month in a row, as the US economy added just 75,000 jobs in May.

Despite the growing signs of weakness in the economy, inflation data are worrying central bankers. (And not just in the US: The BOJ has repeatedly injected funds into the money market in order to curb a sharp rise in overnight rates, the ECB hiked its benchmark rate 25 bp on June 8, and many other countries have followed suit.) Core CPI has now risen 0.3% for two months in a row and is currently at 2.3% year over year. Core PCE, which is the favored index of the Fed, rose at a 2.1% year-over-year pace at last reading. While this is at or just above the upper end of the Fed’s inflation comfort zone, inflation has been relatively stable. At the latest CPI reading, seven of the 29 broad CPI subcategories showed a decline in April, and all but 10 have posted one or more monthly declines in the past year (thank you, David Resler for sharing this observation with us). The “owners’ equivalent rent” (OER) component of the inflation index, at 23% the largest component of CPI, is what is driving the slight uptick in core CPI. OER, a measure of housing costs, imputes what a homeowner would have to pay himself in order to rent his own house. That number is based on what tenants pay for equivalent rental properties. The irony at work here is that one of the most obvious targets of current Fed policy is the housing market. As home prices have soared and as the cost of housing (i.e., mortgage rates) has also risen, affordability has plummeted, particularly for the first-time homebuyer. Thus the success of the Fed at puncturing the housing market has contributed to the rental alternative becoming relatively more attractive, meaning that rising rents will drive up inflation statistics. Arguably, then, the strong housing market’s effect on the rental market may have understated inflation while home price appreciation was strong but may now be overstating it.

Chairman Bernanke’s professed desire to be transparent means that the hawkish tone coming out of the Fed should not be construed as a “head fake,” where the Fed says one thing and does another. We believe that absent a significant market collapse or a data surprise between now and the next FOMC meeting, the Fed will move 25 bp for the 17 th time in a row on June 29 th. From our perspective, a continuation of current Fed policy risks a harder economic landing. In that event, a few things become more likely going forward. First, asset prices at the front end of the yield curve, which is where we invest, continue to be attractive. Second, the benefits of our recent portfolio moves into more floating rate exposure should bear out. Third, the risk of a harder landing implies the potential timing for the easing phase of Fed policy would be that much closer.

The Markets

Equity markets around the world were down in May. Mortgage rates continue to tick up, and the Refi Index declined. Long-dated interest rates stayed near their recent highs. Gold eased and oil barely moved. The disgraced leaders of Enron were convicted and George Bush picked a new Treasury Secretary; both events are noteworthy but not market-moving.

Source: Bloomberg; Japanese Yen quote is the London feed

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