NEW YORK--(BUSINESS WIRE)--
Annaly Capital Management, Inc. (NYSE: NLY) released its third quarter
2012 market commentary providing a review of government policy, the
economy and the residential mortgage, commercial mortgage, asset-backed,
corporate credit and treasury markets. Through its quarterly commentary
Annaly expresses its thoughts and opinions on issues and events it
monitors in the financial markets. Please visit our website, www.annaly.com,
to view the complete
commentary with charts and graphs.
Policy Watch
More than ever, it seems markets and economies around the world are
being driven by policymakers. This is a glib statement to make, as
regulators, central bankers and legislators have always been the other
invisible hand in the functioning of our global economic system.
Nevertheless, the third quarter of 2012 provided many stark examples of
the ways in which policymakers have stepped up control from their
commanding heights.
In particular, September 2012 was a month to remember for watchers of
monetary policy. The European Central Bank (ECB) lowered its deposit
rate to zero, roiling the European money markets. It also instituted a
new program called Outright Monetary Transactions (OMTs) through which
the ECB can buy unlimited amounts of EU sovereign bonds on the secondary
market, so long as the sovereigns in question submit to certain
conditions. The reaction of the markets to this latest pronouncement was
similar to prior announcements on programs or summit outcomes—sovereign
yields fell, which takes the heat off of fiscal policymakers to address
their problems.
Here in the US, the Federal Reserve (Fed) extended its zero interest
rate policy through mid-2015, as expected, but it also introduced two
previously untried policies. First, the Federal Open Market Committee
(FOMC) announced that it intended to expand its holdings of long-term
securities with purchases of $40 billion of additional Agency
mortgage-backed securities (MBS) per month and “if the outlook for the
labor market does not improve substantially, the Committee will continue
its purchases of Agency mortgage-backed securities, undertake additional
asset purchases, and employ its other policy tools as appropriate until
such improvement is achieved in a context of price stability.” This
open-ended policy is a shift from its previous Quantitative Easing (QE)
practice of announcing a set amount of balance sheet expansion with a
defined end date, and has inspired the nickname “QE-infinity”. Second,
the FOMC also signaled a subtle policy shift with the following sentence:
“To support continued progress toward maximum employment and price
stability, the Committee expects that a highly accommodative stance of
monetary policy will remain appropriate for a considerable time after
the economic recovery strengthens.”
What the FOMC is suggesting to careful readers is a change in the Fed’s
normal response function, which hinges on their dual mandate of full
employment and price stability. This statement is telegraphing the
notion that once the economy strengthens, the job market improves, and
inflation begins to pick up, the Fed will not immediately remove
its “highly accommodative stance.” Instead, the Fed will be looking to
make up ground lost during the recession and slow recovery.
Outside of monetary policy, the influence of policymakers is being felt
in three other important areas. First is the so-called fiscal cliff in
the United States, which refers to the combination of expiring Bush tax
cuts and payroll tax cuts, the start of broad mandated spending cuts
under automatic sequestration and other fiscal changes. Economists
calculate that the full effect of the fiscal cliff would be over $600
billion, and the impact of going over the cliff would be enough to
reduce GDP by 4%. Looming over the cliff is America’s debt mountain:
Borrowings by the United States will likely reach their statutory debt
limit sometime in the next several months. Everyone will recall that the
last time this happened, the failure of Washington to adequately address
the problem in a bipartisan way cost America its AAA rating and kicked
the can down the road to this exact fiscal cliff. Second, the
still-unfinished regulatory frameworks of Basel III and Dodd-Frank
continue to cloak the markets in uncertainty in parameters ranging from
bank operations to derivatives execution to securitization rules. And
third, the imminent elections in the United States have essentially
pushed off any possibility of an action plan until all the players are
in place.
In the meantime, market participants muddle through, with shortened
visibility horizons and lowered return expectations.
The Economy
The Federal Reserve was likely unnerved by economic activity that slowed
throughout the summer months of 2012. After peaking at 4.1% in the
fourth quarter of 2011, real GDP growth decelerated to 2.0% and only
1.3% in the first and second quarters of 2012, respectively. Indications
for growth in the third quarter are muted. US manufacturers’ new orders
declined the most in August since early 2009, in the depths of the
previous recession. Durable goods orders did the same, with a very large
-13.2% drop, the third worst monthly drop in the past 20 years (the
others were January 2009 and July 2000). Industrial production and
capacity utilization look similar: the monthly decline in industrial
production in August has not been seen since 2009, and capacity
utilization at 78.2% has rolled over sharply and is now lower than it
was at the end of 2011. The various Federal Reserve regional activity
surveys confirm these data, coming in mixed but mostly negative. The
Chicago Fed National Activity Index, a collection of 85 economic
indicators, printed at -0.87 and suggests an economy growing well below
potential in the third quarter. The ISM surveys, manufacturing and
non-manufacturing, and the Markit Flash PMI all show the same trend of
slowing momentum.
The employment situation in the US has been stubbornly slow to improve.
Though the headline unemployment rate has dropped each quarter of the
year, the disconnect between this metric and all other measures of labor
market health has only been increasing. For instance, while the most
recent report showed a 0.3% drop in unemployment from 8.2% to 7.9%, the
U-6 measure of underemployment, which includes the growing population of
part-time workers, stayed the same at 14.7%. Headline non-farm payrolls
from the Establishment survey has lost momentum, averaging a relatively
sluggish pace of about 146,000 per month in 2012, down from 153,000 last
year.
Labor force participation remains a problem, with a seasonally-adjusted
718,000 workers giving up their job search in this quarter alone. This
stagnation in the labor force growth rate is an important development to
watch. Productivity gains and longer hours can offset a decline in the
number of workers in an economy, but growth in the labor force is an
important determinant of potential GDP growth, as Chart 1 of our online
commentary indicates.
The Baby Boomer generation features prominently in Chart 1 of our online
commentary, as they rolled into the labor force en masse in the
1960s and 1970s and are now beginning to roll out. This kind of a
headwind is more structural than cyclical, and could be a potential
source of the “persistent headwinds” to recovery that the FOMC cited in
the minutes from the September 13 meeting. However, the data tell us
that there are about 6.5 million people not in the labor force who want
to be working. Fed policymakers remain hopeful that their monetary
policy will provide the spark to put them back to work.
Residential Mortgage Market
In an attempt to “support a stronger economic recovery,” the Federal
Reserve eased further on September 13, adopting highly accommodative
policy that has Agency MBS at its core. The Fed will re-start outright
monthly purchases of Agency MBS above and beyond simple reinvestment of
its existing holdings. The Fed believes this policy “should put downward
pressure on longer-term interest rates, support mortgage markets, and
help to make broader financial conditions more accommodative.”
Per the Fed’s release, it will commit to purchasing $40 billion in
Agency MBS monthly in addition to reinvesting all principal payments
from its current holdings, estimating that combined purchases for the
two programs will ultimately total roughly $85 billion per month. While
$85 billion in monthly purchases pales in comparison to the overall size
of the Agency universe, roughly $5.4 trillion, it is significant when
compared to monthly fixed-rate mortgage origination. Table 1 of our online
commentary, with data provided by Bloomberg, illustrates monthly 15
to 30 year Fannie Mae, Freddie Mac and Ginnie Mae fixed-rate mortgage
origination year-to-date. Using the historical average of $25 billion
per month of reinvested principal as part of the System Open Market
Account (SOMA) and QE3 of $40 billion, the federal government will end
up owning the overwhelming majority of monthly mortgage origination.
The weight of these purchases on the market is significant, and market
participants are managing through all the potential ramifications,
including lower primary mortgage rates, changes in mortgage spreads and
prepayment expectations.
Commercial Mortgage Market
The announcement of QE3 by the Fed enabled spread products to continue
their rally in pricing. For commercial mortgage-backed securities
(CMBS), which we noted last quarter were attractive on a relative value
basis, the benefits have inured to pre-2008 legacy bonds as well as
newer issues, referred to affectionately as CMBS 2.0.
For new issues, spread movements have been particularly strong. During
the quarter ended September 30, 2012, 10-year AAA new issue spreads have
rallied from swaps +150/160 basis points (bps) to a level of swaps
+85/95 bps. 10-year AAA legacy CMBS have likewise benefited, rallying
from approximately swaps +230/235 bps to swaps +155/160 bps. Mezzanine
bonds rated BBB and BBB- have seen spread tightening on the magnitude of
125 bps and 200 to 225 bps, respectively.
The price rally across the capital stack has allowed CMBS lenders to be
more competitive in the market. The spread rally and resulting lending
competitiveness has led to speculation that CMBS issuance for 2012 could
approximate $40 billion to $45 billion, an increase of $15 billion to
$20 billion from initial estimates.
So if CMBS lending comes roaring back, how will the portfolio lenders,
banks and insurance companies respond to the competition? For properties
that meet portfolio lenders’ lending objectives, we expect the lenders
to remain competitive in providing financing. Commercial mortgages, even
at current historically low rates, still exhibit good relative value
against other fixed income alternatives.
However, we are in an environment where the search for yield may be more
important than fundamentals, where pricing may not reflect the
cyclicality embedded in commercial real estate. Property markets and
property types move in and out of favor. Systemic changes to the office,
residential and retail environments resulting from technological
advances will impact how and where people work, live and shop. This
analysis will become more acute even as pressures remain to invest long
term at historically low yields.
Asset-Backed Securities Market
The asset-backed securities market had another quarter of robust
issuance which was met with very strong demand from investors seeking
higher yielding assets. According to statistics provided by JP Morgan,
asset backed issuance for the third quarter totaled approximately $48
billion with almost $21 billion coming in September alone. Total 2012
year-to-date issuance has already surpassed full year issuance for 2011,
currently at $153 billion compared to $139 billion last year.
While auto receivables continued to dominate supply ($20 billion) during
the quarter, credit card issuance surged to a respectable level of $13.5
billion with large deals from Citibank, JPM/Chase and Discover.
Year-to-date issuance in the credit card sector is $31 billion versus
$14 billion for all of 2011. This quarter even saw U.S. dollar
denominated deals backed by Canadian credit card receivables and UK auto
loans. The esoteric segment (containers, structured settlements, tax
liens, rental cars, fleet leases, dealer floorplans, rehabilitated
student loans and insurance premiums) experienced an increase in
issuance during the quarter which is not surprising given the low
funding costs and robust demand from yield hungry investors.
Interestingly, the non-Agency residential mortgage sector showed signs
of life as several new issues came to market. Issuance in this sector
has been quite limited since the onset of the credit crisis, and the new
deals were heavily oversubscribed.
The asset-backed sector continued to deliver stable returns during the
third quarter on both a total return and excess return basis due to a
voracious appetite from investors. The favorable performance was broad
based across multiple sectors and was driven by strong underlying
collateral credit performance, superior relative yields and spread
tightening that occurred during the quarter, particularly in the
residential-related (home equity and manufactured housing) sectors.
These segments rallied in response to improving consumer sentiment,
continued improvement in home prices, and the Fed’s third round of
quantitative easing. While the program was largely anticipated,
continued efforts to re-inflate housing through monthly purchases of
mortgage-backed securities led investors to look for alternative
investments in the residential mortgage sector. Consumer and commercial
segments also turned in a respectable performance despite persistently
low interest rates across the yield curve.
Subordinated tranches of credit cards and autos also tightened during
the quarter as investors sought opportunities to move down the capital
structures for additional yield.
Total 2012 issuance is expected to reach $190 billion. The consumer
asset-backed sector is perceived to be a safe haven for investors and
spreads will likely remain tight absent severe economic weakness or a
recession. The dearth of high quality bonds and the large amounts of
cash needing to be invested will likely keep technicals strong for the
foreseeable future.
Corporate Credit Market
The broad theme in corporate credit in the third quarter has been the
response to the Federal Reserve’s efforts to push investors out on the
risk curve to meet their yield goals by accepting longer duration, lower
credit quality, or lower liquidity. Spurred by global monetary policy,
and aided by fundamental credit improvement since the crisis, flows into
the sector continue driving yields and spreads to historic lows.
In the investment grade market, spread tightening in the third quarter
of 2012 has been driven mainly by the financial sector. There is
fundamental and technical support for this move in the form of balance
sheet improvement and lower supply. The vast improvement to post-crisis
tights in valuations of financial institutions vis-à-vis their
industrial peers can be seen in Chart 2 of our online
commentary.
Over the past year financial institution debt outstanding, as measured
by the Barclays Capital index suite, has expanded from $1.06 trillion to
$1.14 trillion, an increase of 7.5%, while industrial debt outstanding
has increased by a much larger 17% ($1.7 trillion to $2.0 trillion).
Since 2008, the difference is even clearer – financial debt outstanding
has increased by 41% while industrial debt outstanding has increased by
122%. The broad improvement in credit spreads is further supported by
the demand side of the equation. As an indication of demand, shares
outstanding in the popular iShares Barclays Aggregate Bond Fund ETF
(AGG) have increased by 16% over the last 12 months, outstripping
overall supply growth by 4%.
Importantly, the increase in indebtedness has come in the context of
increased earnings and liquidity, resulting in broadly improved credit
quality since the depth of the credit crisis. Indeed, the relatively
small increase in financial debt outstanding (compared with industrials)
supports the sector’s relative outperformance. With respect to
financials, while complying with Basel III should de-risk balance
sheets, recent data show an easing of lending conditions at banks,
continuing positive growth in C&I loans, and positive growth in consumer
loans for the first time since the crisis. On the industrial side, the
reduction in leverage seen over the past few years has stopped and in
some cases reversed.
Non-investment grade yields continue to notch all time lows, currently
at about 6.25%. There is marginal support at these levels based on
expectations for low default rates and demand from non-traditional
investors such as retail and crossover investment grade buyers. With
respect to retail, shares outstanding in popular ETFs SPDR Barclays
Capital High Yield Bond (JNK) and iShares iBoxx High Yield Corporate
Bond Fund (HYG) are up 36% and 50% year to date, respectfully. These
vehicles were fairly effective in providing liquidity in the 2008
crisis, but they were much smaller then; The next crisis will be the
real test in the liquidity mismatch between the high yield ETF market
and their underlying securities.
Treasury/Rates Market
The third quarter had some choppiness in yields but the period ended
with most maturities higher in price and the curve quite a bit steeper.
There was about a 40 bps range in intermediate maturity yields with two
roundtrips – a push to lower rates followed by weakness. The first trip
to lower rates occurred in July and actually recorded a new low for the
10-year to below 1.40%. Economic numbers came in slightly better than
expected throughout the quarter as the Citi Economic Surprise Index
turned slightly positive after a disappointing second quarter. That
said, this had more to do with expectations being ratcheted down than
legitimate strength in the data. Overall volatility continued to wither.
After the September FOMC meeting, the initial reaction was a steepening
selloff but while much of the steepness persisted, the selloff didn’t
last more than a day. The immediate impact of the Fed’s mortgage buying
drove yields lower quickly. Ten-year Treasury yields went from 1.76%
before the FOMC meeting to 1.87% the day after and then back down to
1.63% to end the quarter.
One dynamic that persisted in the wake of the Fed’s decision was a
historically steep spread between 10-year Treasury and 30-year Treasury
rates, a spread that is commonly associated with some measure of
inflation expectations and term premium. The aggressive action by the
Fed and accompanying rhetoric that they were prepared to leave these
accommodative policies in place well through the initial stages of an
eventual economic recovery were clearly interpreted by the market as
materially reflationary. Looking at Chart 3 in our online
commentary, we see that the spread between 10-year and 30-year
Treasurys (in green) is quite substantial at 123 bps, but not quite at
its peak from late 2010. What this misses however is that no two spreads
are alike: Yields were meaningfully higher in 2010 (around 3.00% for the
10-year compared to 1.7% at this writing) and the proportion of the
10-year to 30-year spread to the level of yields is actually much higher
now. As a means of demonstrating this, the blue line is simply the ratio
of 30-year yields to 10-year yields. In other words, the spread at the
long end of the yield curve is as wide as ever, but it evidences a
relative reluctance to invest in 30-year bonds that has never been
higher.
*Please direct media inquiries to Jeremy Diamond at (212)696-0100
This material is not intended to be relied upon as a forecast,
research or investment advice, and is not a recommendation, offer or
solicitation to buy or sell any securities, including securities of
Annaly Capital Management, Inc. or any other company, or to adopt any
investment strategy. All information and opinions contained
herein are derived from proprietary and nonproprietary sources believed
to be accurate and reliable. However, such information is presented “as
is” without warranty of any kind, and we make no representation or
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completeness of any such information or with regard to the results to be
obtained from its use, and we do not undertake to advise you of any
changes in the views expressed herein. While we have attempted to make
the information current at the time of its release, it may be or become
outdated, stale or otherwise subject to a variety of legal
qualifications as conditions change. No representation is made that we
will or are likely to achieve results comparable to those shown if
results are shown. Reliance upon information in this material is at the
sole discretion of the reader. ©2012 by Annaly Capital Management,
Inc./FIDAC/Merganser. All rights reserved. No part of this commentary
may be reproduced in any form and/or any medium, without our express
written permission.
Annaly Capital Management, Inc.
Media inquiries:
Jeremy
Diamond, 212-696-0100
or
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Source: Annaly Capital Management, Inc.