“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 MarketThe 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 MarketThe 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 warranty, express or implied, as to the accuracy, timeliness, or 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.