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Yield Curve flattens on flight to quality trade and QE

MR - Twos TensEnlarge Graph

The shape of the yield curve matters almost as much as the absolute level of interest rates to financial companies

As a general rule, financial companies (banks, REITs) borrow short and lend long. What this means is that they lever their balance sheet by borrowing at short term interest rates and generally invest in longer-maturity assets such as commercial loans or mortgages. The spread between the two rates is their profit. The steepness of the yield curve (or the difference between short term rates and long term rates) directly influences their profitability. While there are many different ways to measure the steepness of the yield curve, the twos / tens spread – or the difference between the yield on the 10 year bond and the two year bond – is one of the more popular ways to do it.

The shape of the yield curve usually gives clues as to the direction of the economy. When the yield curve is steep (in other words long-term interest rates are much higher than short term rates) that usually signals the economy is picking up steam and investors are starting to price in inflationary risks. When the yield curve is flat, or inverted that is a signal that the economy may be slowing.

The signals coming from the yield curve are distorted by the Fed

In a normal environment, the yield curve is mildly sloping upward. This is not a normal environment, however. The Fed is pushing long-term rates lower by purchasing Treasuries directly in the market. In fact, the Fed is buying roughly 70% of all new issuance from the Treasury. This means that the normal signals coming from the shape of the yield curve are distorted.

Over the past few weeks, a number of different events have occurred which have lowered long term interest rates in the US, or flattened the yield curve. The first was the Cyprus banking situation, which caused fears of a Euro contagion and a flight to quality. The second was the announcement that the Bank of Japan is conducting its own quantitative easing program, which has had the effect of driving Japanese investment out of JGBs (Japanese Government Bonds) and into Treasuries. The final event was Friday’s anemic jobs report, which was weak enough to convince the Fed to continue its quantitative easing program. Chicago Fed President Charles Evans went as far as to say “I’m going to have a lot more confidence if I begin to see indications that growth is well above trend and its going to be sustainable.” In other words, we are nowhere near where we need to be in order to end QE.

Implications for the mortgage REITs

A flattening yield curve is a double edged sword for mortgage REITs like AGNC, NLY, or HTS. On one hand, as yields fall, it means that the price of their assets is increasing, which gives them mark-to-market gains. On the other hand, it means that their interest margins are decreasing, which hurts their profitability. If the yield curve is flattening because long term interest rates are falling, prepayment speeds could increase, which creates reinvestment risk. Of course how the Fed ends quantitative easing will affect the REITs even more – do they stop buying and let the paper mature? Do they sell? The exit of QE may in fact be dangerous. However, the latest data points indicate that probably is a 2014 event.

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