NEW YORK--(BUSINESS WIRE)--
Annaly Capital Management, Inc. (NYSE: NLY) released its monthly
commentary for September providing a review of the economy and the
residential mortgage, commercial mortgage, corporate credit and Treasury
markets. Through its monthly commentary and blog, Annaly
Salvos, Annaly expresses its thoughts and opinions on issues and
events in the financial markets. Please visit our website, www.annaly.com,
to check out all of the new features and to view the complete commentary
with charts and graphs.
The Economy
August economic data were weak, including initial jobless claims ticking
up, retail sales less than robust, and nonfarm payrolls positive but
still anemic. As expected, second quarter GDP growth was revised lower,
to 1.6% from 2.4%, and Wall Street economists and strategists are slowly
beginning to take down their expectations for future quarters.
At the annual Jackson Hole conference, Chairman
Bernanke gave a speech that offered a pretty clear-eyed assessment
of the recovery. Despite his acknowledgement that “[c]entral bankers
alone cannot solve the world’s economic problems,” the markets viewed
his remarks as dovish largely due to his conclusion that “the FOMC will
do all that it can to ensure continuation of the economic recovery.” As
for what the Fed could do in the event growth deteriorates further, he
repeated much of what he’s already said on the subject:
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Additional purchases of longer-term securities, otherwise known as the
“portfolio balance channel,” which he suggested works best when
financial conditions are poor and liquidity is tight (which is not the
current situation).
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Modifying the FOMC’s communication to say it would be “keeping the
target for the federal funds rate low for a longer period than is
currently priced in the markets.” This would presumably restrain
long-term inflation expectations.
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Lastly, the Federal Reserve (the Fed) could lower rates paid on excess
reserves held by banks at the Fed. They are currently paying 0.25% on
these reserves, and ostensibly this would cause the banks to push
these reserves out into the money supply by issuing new loans. The
Chairman stated that the effect of a move like this would likely be
negligible for the economy, but it could be disruptive to the money
markets.
He went on to mention that some economists were calling for the FOMC to
increase its inflation goals “above levels consistent with price
stability.” Bernanke went on to dismiss the idea, saying that there was
no support from the committee and it would be an inappropriate action
given his belief that inflation expectations were already “reasonably
well-anchored.”
He didn’t give any hints that they were ready to do anything further.
What are the hurdles to further action? Will sub-par growth be enough,
or does GDP growth have to turn negative? The Wall Street Journal’s
fly-on-the-wall at the Fed, Jon Hilsenrath, wrote about an internal
debate at the Fed about what (if anything) should be done going forward.
In brief, the debate is about whether to do more now, or to wait and see
how things develop and be reactive to future weakness as it arrives.
We believe the Fed is also worried about a deflationary scenario similar
to Japan. Central bankers typically think of deflation (or too-low
inflation) as being caused by a slump in aggregate demand, and they
believe that they have several channels by which they can address it.
The diagram, available in our online
version, is taken from a 2002 New York Fed paper entitled “The
Monetary Transmission Mechanism.” It illustrates the classical model
that central bankers use—beginning with open market operations creating
reserves in the banking system, and ending with aggregate demand.
The “portfolio balance channel,” as Bernanke called it in his Jackson
Hole speech, is not on the diagram in our online
version. According to Bernanke, the portfolio balance channel “holds
that once short-term interest rates have reached zero, the Federal
Reserve's purchases of longer-term securities affect financial
conditions by changing the quantity and mix of financial assets held by
the public.” We saw how the Fed’s purchases of MBS and Treasuries sent
buyers into other asset classes like investment grade and high yield
corporates. If the diagram in our online
version were updated to 2010, the portfolio balance channel would
likely be squeezed in on the right side near the Monetarist channel. In
any event, the bottom line is still aggregate demand, and the assumption
is that higher aggregate demand will take care of a deflationary or
excessively disinflationary scenario.
With this in mind, we read a speech delivered by Minneapolis Fed
president Narayana Kocherlakota on August 17 to an audience at Northern
Michigan University entitled “Inside
the FOMC.” It starts out as a professorial recitation of what a
regional Fed president does every day, but towards the end Kocherlakota
challenges the central banking tenet of reliance on the interest rate
channel to target aggregate demand (emphasis is ours).
It is conventional for central banks to attribute deflationary outcomes
to temporary shortfalls in aggregate demand. Given that interpretation,
central banks then respond to deflation by easing monetary policy in
order to generate extra demand. Unfortunately, this conventional
response leads to problems if followed for too long. The fed
funds rate is roughly the sum of two components: the real,
net-of-inflation, return on safe short-term investments and anticipated
inflation. Monetary policy does affect the real return on safe
investments over short periods of time. But over the long run, money is,
as we economists like to say, neutral. This means that no matter what
the inflation rate is and no matter what the FOMC does, the real return
on safe short-term investments averages about 1-2% over the long run.
Long-run monetary neutrality is an uncontroversial, simple, but
nonetheless profound proposition. In particular, it implies that if the
FOMC maintains the fed funds rate at its current level of 0-25 basis
points for too long, both anticipated and actual inflation have to
become negative. Why? It’s simple arithmetic. Let’s say that the real
rate of return on safe investments is 1 percent and we need to add an
amount of anticipated inflation that will result in a fed funds rate of
0.25%. The only way to get that is to add a negative number—in
this case, –0.75%.
To sum up, over the long run, a low fed funds rate must lead to
consistent—but low—levels of deflation.
Bernanke said in his Jackson Hole speech that his goal, if necessary,
would be to make the markets think that the Fed would keep rates low for
longer than expected. Kocherlakota says that this prophecy will become
self-fulfilling, becoming precisely the thing that will cause
deflation, not simply prevent inflation. If ultra-low
rates become entrenched, deflation is actually necessary for investors
to reach their required rate of return on risk-free assets. This sounds
exactly like Japan, where a deflationary mindset has become entrenched.
This is part of the reasoning for committing to low short rates, but
also including an inflation target or specifying a timeline for zero
rates. Both would have the effect of keeping inflation expectations
positively anchored if they began to turn negative. With the economy
weakening again, the risk of deflation may be more real than the
Chairman let on in his Jackson Hole speech.
The Residential Mortgage Market
For the week ending August 27, mortgage contract interest rates remained
at historically low levels (conforming 30-year fixed rate mortgages
averaged 4.43% while the 15-year conforming rate dipped to 3.88%).
Prepayment speeds in August (September release) for 30-year Fannie Mae
MBS increased 27% from the previous month, from 18.5 Constant Prepayment
Rate (CPR) to 23.5 CPR. The 2008-2009 4.5% and 5% coupons in particular
paid faster than expected; despite tighter underwriting standards
applied to these loans, borrowers have been able to capture the rate
incentives. Freddie Mac prepayments increased 32% in August to 32 CPR
from 19.7 CPR in July, with the lower coupons paying faster than
expected. The talk of a refinancing wave occurring seems to be aimed at
the lower end of the coupon stack with the higher end remaining stagnant
due to credit impairment or negative equity. Going forward, capacity
constraints to refinancing activity are easing as originators are
hiring. “Smaller and more nimble lenders have led the way so far,” write
analysts at JP Morgan, “and major originators are also adding staff in
the area of underwriters and loan officers.”
Everything is related in the mortgage market, and two other headlines
hit the market recently that provoked market discussion. First is the
news that the FHA is ramping up its previously announced program of
“short-refis,” where a lender has the ability to write down underwater
mortgages and put them into the FHA. Loans held by Fannie Mae and
Freddie Mac are not eligible. The efficacy of the program is in doubt
for several reasons: it is only open to borrowers who are current, which
lessens the attractiveness to lenders; participation is voluntary on the
part of lenders; second-lien holders would have to cooperate and there
is an inherent conflict because the largest second-lien holders also
service the primary mortgage; and borrowers who benefit will nonetheless
get hit in their credit rating. Like other government-instigated
modification programs, the effects of this program are likely to be
marginal at best. Morgan Stanley’s research team estimates that while
1.5 million non-conforming borrowers may be eligible, just 20% to 40%
would actually participate.
The other headline of note popped up on the front
page of the New York Times on the day before Labor Day: “Housing
Woes Bring a New Cry: Let the Market Fall.” The article points out that
even as policymakers have exhausted many options to help housing—tax
credits, mortgage modification programs, foreclosure avoidance programs,
direct assistance, government-backed mortgages and, of course,
record-low mortgage rates—the housing market continues to suffer. The shadow
inventory of homes for sale puts supply at a mammoth 26 months at
current sales pace, the expiration of the housing tax credit was quickly
followed by a dramatic slump in sales, and the re-default rate on
modified loans remains high. The question for policymakers is the
standard one: if there is strong evidence that a policy isn’t working,
do you change the policy or double down? This particular article, penned
by David Streitfeld, suggests that more market observers are coming to
the conclusion that the best option for now would be to allow the market
to find its clearing price.
The Commercial Mortgage Market
During August, the American Council of Life Insurers (ACLI) issued its
Second Quarter 2010 Commercial Mortgage Commitments report. As we noted
in our June
monthly commentary, the life insurance companies have been the
primary source of debt capital for commercial real estate. Consequently,
their pricing information and commitment volumes are illuminating in
terms of asset allocation, pricing and strategy. This month we analyze
the latest data to glean further insights.
In the June 2010 commentary, we reviewed the first quarter ACLI report
and estimated that commercial mortgage spreads for newly originated
loans would continue to tighten in concert with high-grade spread
products. In fact our estimates were within 25 basis points (bps) of the
amounts reported for the period, as depicted in the yellow dashed line (chart
available in our online
version).
Has the commercial mortgage spread compression abated or will there be
further tightening? We anticipate that by the time we receive the third
quarter ACLI report it will show further tightening, as depicted by the
red dashed line (chart available in our online
version). We come to this belief because one of the best
proxies for relative value when pricing commercial mortgages is
high-grade corporate bonds, both public and private. Structurally, the
instruments share common ground. Many corporate bonds are issued with 5-
and 10-year maturities similar to the favored durations for commercial
mortgages. Both instruments are also call-protected, which enables a
good match between assets and liabilities.
Another reason we expect to see further spread tightening is the rally
in commercial mortgage rates that we noted. In the graph available in
our online
version, we have plotted the reported commercial mortgage coupons to
the amount of commitments made by insurance companies as reported by
ACLI for the period ending June 30, 2010.
While the transaction volume has been relatively consistent, ranging
from $1.5 billion to $2.1 billion per month, mortgage coupons have
rallied 140 basis points over the same period. One could argue that
competition from other sources caused the precipitous drop. Yes, excess
money flows from fixed income investors attracted to the excess spread
versus high grade corporate and commercial mortgages came into the
market, but there was still little traction from CMBS conduit
commitments. So why did the coupons drop? We believe the lack of new
investable product steered the insurance companies into a position where
they bid against themselves to gain business. A 6.5% mortgage may look
really good one day, but 6.25% might look even better the next day.
The lower coupons, engineered by a price war among the various insurance
companies, coupled with the rally in the super-senior tranches of CMBS,
has led to signs of life in the CMBS conduit lending programs. Thus the
insurance companies appear to be sowing the seeds of competition that
will put further pressure on their mortgage coupons.
The Corporate Credit Market
One would think this golden age of fixed income would be more enjoyable.
But many have been surprised by just how low yields have fallen this
year. One attributing factor is the flood of new investor money into the
sector, an almost daily press headline. This unprecedented technical
overshadows an equally important fundamental force in the fixed income
markets, the slower growth or outright contraction in investible product
due to private sector deleveraging.
Bond indices show the most up-to-date snapshot of the big picture. As
seen in the charts available in our online
version, the annual change in the dollar volume of outstanding bonds
in different sectors of the Bank of America Merrill Lynch bond indexes
is either decelerating or shrinking. The chart on the left (see online
version) represents the big sectors— Treasuries, Mortgages,
Investment Grade Corporates, and Agencies— which account for 90% of the
domestic aggregate benchmark. The chart of the right (see online
version) is the “alpha” or “core plus” sectors—ABS, CMBS,
High Yield and Emerging Markets— which are commonly a source of
outperformance to the benchmark. While the growth of net Treasury supply
has exploded since late 2008, the growth in other sectors is either
stagnant or shrinking. The exception is investment grade (IG), high
yield (HY) and emerging markets.
With all the talk of corporate balance sheet deleveraging, the trend in
the corporate credit sectors may come as a surprise. The net supply of
IG and HY index-eligible assets has grown a respective 11% and 16% in
the past year. There are several drivers to consider. First, firms are
managing their liquidity very differently than in the past. This is
partly in memory of the crisis-era problems with short-term funding and
bank lines. Commercial paper (CP) outstanding for nonfinancial firms
stands at a mere $128 billion, a far cry from peak balances of $350
billion in 2000. One has to wonder what ever happened to the old
practice of using CP to manage short term variance in working capital.
For domestic and foreign financial CP, balances now stand at $520
billion; this compares to an $854 billion peak in early 2008. Recent
changes to money market fund guidelines which tighten the credit quality
and maturity of fund holdings could bring these balances down further in
the months ahead. Moreover, the rating agencies view of a financial
firms’ liquidity changed in the crisis era. They like to see sufficient
cash to pay off over 1.0x the bond maturities of the next 12 months. So
don’t count on those cash balances to fall. More broadly, it appears the
in the aftermath of the crisis industrial and financial firms are both
holding more cash and issuing more long-term debt, a strange barbell
indeed.
IG and HY are growing for different reasons. The IG market is comprised
of numerous multinational companies that spew massive amounts of cash.
Many of these firms issue debt and buy shares to target optimal
leverage. Alternatively, firms can use cash to fund acquisitions. The
drivers of share repurchases and mergers stem from the fact that over
the long run, excess liquidity can depress return on equity. As a
result, there is a nominal component to the level of balance: as
retained earnings grows so does debt outstanding (particularly at
today’s relative prices). Simply put, it should grow with time.
The HY market is still undergoing “cures” that have supported gross
issuance. Thanks to a very active August, year-to-date supply tallies to
$128 billion. However, bond and loan refinancing reflect 61% of the use
of proceeds. Thus, companies continue to pay down bank debt with less
restrictive bond debt and extend maturities. The “bonds for loans”
explains part of the rise in debt bond supply. According to LCD,
Standard & Poor’s leveraged finance research unit, the par amount of
leveraged loans outstanding is 14% below the 2008 peak. But that’s not
the complete story. A couple of other factors are contributing to rising
net HY supply: 1) M&A 2) special dividends; and 3) reemergence from
bankruptcy. The first two forces relate partly to financial sponsors.
Financing periods are closing which will force exits. Furthermore, as
the Bush tax cuts sunset at the end of 2010 both dividend and capital
gain taxes are likely to rise. Thus, sponsors are incented to engage in
equity monetizations, such as recaps and special dividends, market
conditions permitting. Already, $5.2 billion in equity monetization
deals have been priced this year, the largest since 2006. We also expect
more bankruptcy-exit-related financing as firms emerge from Chapter 11
or paydown previously issued exit-loan debt. In contrast to consumer
debt where default represents a decline of net supply and the borrower
will likely be shut out of the market for years, large cap companies
re-emerge from bankruptcy and have capital markets access much sooner.
The corporate supply outlook is evolving. Some of new supply is recycled
and some is fresh but it does not necessarily mean credit fundamentals
are eroding. If the spread product market is starved for product, then
this is a good thing.
The Treasury/Rates Market
The Treasury market had another unusually strong month in August. The
difference was that longer maturities outpaced the rest of the curve and
recouped some of their underperformance from previous months. Ten-year
and 30-year rates rallied about 45 basis points while 2-years and
5-years were just 9 and 28 bps richer respectively. The sell-off in
equities of about 5% on the month contributed to the price action, but a
combination of a dovish Fed and softer economic data were supportive as
well. The notion of the economy muddling forward with subpar growth
became more firmly entrenched as did the belief that the Fed will not be
raising rates any time soon. The Fed did nothing to dissuade investors
from that belief when they announced at the conclusion of the August 10th
FOMC meeting that they would be reinvesting principal paydowns from
their Agency MBS portfolio into U.S. Treasuries. The market was split on
the reinvestment possibility, but the takeaway is that the bar for the
next level of quantitative easing, commonly known as QE2, has been
lowered.
While the Fed’s decision to reinvest portfolio paydowns aided the long
end of the curve, the completion of the mid-August supply (3-years,
10-years, and 30-years) also improved the dynamic. On the month, the
Treasury auctioned $176 billion of nominal notes and bonds. In summary,
the auctions went well with few surprises: the auctions were all priced
at levels that were close to market pricing at the time of the auction.
Going forward, the main question investors will ask themselves is what
will push the Fed over the threshold of embracing further monetary
stimulus. The market seems to be unanimous in the belief that the
stimulus baton will need to be carried by fiscal activity. But there are
still a handful of measures the Fed can implement to stoke the economy,
perhaps in conjunction with fiscal stimulus, as discussed above. Of the
three, it is the notion of QE2 that seems to have the most momentum, on
the heels of the reinvestment decision. All eyes are on the economic
releases to gauge whether we could see an announcement as soon as this
fall.
In this context it makes sense to revisit the impact of the Fed’s
announcement on Treasury rates at both stages of the first round of
quantitative easing, or QE1. On November 25, 2008, the Fed announced its
intent to purchase $100 billion in Agency debt and $500 billion in
Agency MBS (we call it QE1a in the graph available in our online
version). The impact on rates and the shape of the curve was
immediate and sizable as can be seen in the chart in our online
version—the blue line is the 10-year yield and the red line is the
spread between the 2-year and the 10-year, a proxy for the yield curve.
When financial and economic conditions failed to improve, the Fed came
back with a vengeance increasing the totals for Agency debt and MBS to
$200 billion and $1.25 trillion, respectively, and adding $300 billion
in Treasuries to the mix (QE1b). The initial impact was significant from
the second round but concerns began to surface that the Fed was
monetizing the debt of the government. In fairly short order the impact
was reversed as investors took interest rates higher and the yield curve
steeper.
This time around, the bar for more QE is undoubtedly high. Further, talk
of debt monetization is low and the economic foundation for low yields
and a flat curve seems rock solid. But it is worth demonstrating that
the impact of further Fed purchases from here may not bring the desired
effect.
September 10, 2010
Jeremy Diamond*
Managing Director
Robert Calhoun
Vice President
Frederick Diehl
Vice President
Mary Rooney
Executive Vice President
*Please direct media inquiries to Jeremy Diamond at (212)696-0100
This commentary is neither an offer to sell, nor a solicitation of an
offer to buy, any securities of Annaly Capital Management, Inc.
(“Annaly”), FIDAC or any other company. Such an offer can only be made
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including the loss of some or all principal. All information contained
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However, such information is presented “as is” without warranty of any
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comparable to those shown if results are shown. Results for the fund, if
shown, include dividends (when appropriate) and are net of fees. ©2010
by Annaly Capital Management, Inc./FIDAC. All rights reserved. No
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Source: Annaly Capital Management, Inc.