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Foreign demand for US assets is a big determinant of interest rates
Foreign demand for US financial assets helped push US interest rates to record lows during last summer. Fears of a European contagion fed a flight to quality, which pushed the 10 year yield down to below 1.4%. While that sort of yield is certainly paltry compared to what we have historically been able to earn on Treasuries, compared to the rest of the world, 1.4% is competitive. Even today, with the 10-year bond yielding under 1.7%, it is helpful to remember that the 10 year Japanese Government bond yields 61 basis points. In Germany, you will get 1.25% to tie your money up for 10 years.
The other driver of foreign purchases of US assets is the trade deficit. When our trading partners receive dollars in exchange for their goods, they have two choices: they can use the dollars to purchase US goods and services, or they can use the dollars to purchase US financial assets. Large export-driven economies like China are more apt to run large trade surpluses, which means they are forced to hold a lot of US assets.
As global economic fears subside, money leaves US assets
The biggest driver of the decrease was global economic stability. Foreign investors pulled their money out of US Treasuries as part of the “risk on” trade. During the month of February, foreign investors sold over $17 billion worth of US stocks, bonds, and other financial assets. In January, they purchased a net $25 billion. To put these numbers in perspective, the Fed purchases $45 billion worth of Treasuries a month. So while foreigners do have an impact, the Fed is the 800 pound gorilla in the US sovereign debt market
Implications for mortgage REITs
The absolute level of interest rates is a prime driver of mortgage REITs like AGNC, NLY or CMO. Mortgage-backed securities closely track the level of long term Treasuries, although there are not quite as sensitive. As interest rates fall, their interest margins fall, which is the difference between the rate of return on their assets and their borrowing costs; this drop will reduce their profitability.
Falling interest rates also affect another important factor for mortgage investors, which is prepayment speed. Homeowners are allowed to pay off their mortgage early, without penalty. So when interest rates fall, those that can refinance at a lower rate will do so. This is something that is good for homeowners, however, it isn’t necessarily a good thing for mortgage lenders, especially REITs. When homeowners prepay, the investor loses a high-yielding asset and is forced to re-invest the proceeds in a lower rate investment. This means lower returns going forward.
© 2013 Market Realist, Inc.