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Capacity utilization drops in April

Capacity UtilizationEnlarge GraphCapacity utilization is a bellwether of economic activity

Capacity utilization is a good top-down macroeconomic indicator, which helps forecast the labor market, final demand, consumption, and inflation. While manufacturing is no longer the primary driver of the U.S. economy, it still influences the economy to a large degree, particularly for unskilled workers. U.S. manufacturing is undergoing a bit of a renaissance lately due to cheap energy prices. While there is still a difference between wages overseas and here, low natural gas prices are offsetting that. Also, as wages rise overseas, the cheap labor arbitrage is fading away. The Fukushima nuclear disaster also demonstrated how elongated supply chains are vulnerable.

Increases in capacity utilization generally signal increases in employment and capital expenditures. Lower skilled workers have struggled since the financial crisis, which has dampened aggregate demand and consumption. Things are finally starting to improve as construction jobs rebound and more companies are starting to move towards on-shore production. Increased capital expenditures are a big economic driver as well. Corporations have been in maintenance capital expenditure mode for a long time.

Capacity utilization rates are approaching long-term historical averages

Capacity utilization was 77.8% in April, a rise of 50 basis points from March. Capacity utilization has been rising steadily since the economy bottomed in 2009. Over the past year, it has risen by 10 basis points.

From 1972 to 2012, capacity utilization has averaged 80.2%. It was highest in the early 1970s, peaking at around 89%. It bottomed at 66.9% in 2009. This suggests that there is a lot of room for production to expand before we start having inflationary pressures. High capacity utilization levels in the 1970s were a big cause of inflation.

Impact on mortgage REITs

Industrial production and capacity utilization are numbers that get a lot of focus at the Fed. They not only help forecast economic activity, but also are important inputs into inflation. While the Fed believes the problem with inflation is that it is too low, eventually that will change. They certainly will be happy to see capacity utilization approaching long-term historical averages.

While inflation is completely under control, the Fed will take capacity utilization into account when formulating policy. Right now, the only economic statistic that really matters is unemployment – everything else is secondary. This means that quantitative easing will probably continue for the rest of the year and low interest rates are here to stay.

For the mortgage REITs, such as American Capital (AGNC), Annaly (NLY), and Capstead (CMO), that means low financing costs and higher prepayment speeds. Low financing costs help keep interest spreads wide, while higher prepayment speeds depresses returns. When the Fed ends quantitative easing, the REITs could see a steepening of the yield curve, which will be a great thing for them. Until then, the Fed will drive mortgage rates and the fate of the REITs is largely in the hands of the Fed.