How much steeper can the yield curve get?
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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. The yield on the 10-year bond less the Fed Funds target rate is one way to measure the steepness of the yield curve. The two’s/ten’s spread is another.
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 month, long-term interest rates have vaulted higher as the Fed has indicated it could end asset purchases by the end of the year. That said, it isn’t just Treasuries that are falling, G7 yields are increasing in lockstep.
One of the questions that has been asked is: “how steep can the yield curve get?” The chart above should give some perspective. For the entire length of the chart, the Fed Funds Target Rate has been 25 basis points. We can see that even during the environment of QE I (which started in December 2008 and lasted until March 2010) and QEII (which lasted from November 2010 to June 2011), the 10-year spread to the Fed Funds target rate has been much higher (around 2.5%). This would imply a 2.75% 10-year bond yield, a big jump from here. Note that at one point, the spread was almost 4%, which would mean a 4.25% 10-year. So even though we have had a big back up in rates, compared to where we have been since the Fed lowered the Fed Funds rate to 25 basis points, it isn’t really all that big of a move. And that is why the mortgage REITS have been getting clocked.
Implications for mortgage REITs
Increasing interest rates is generally bad news for mortgage REITs, like American Capital (AGNC), Annaly (NLY), or Hatteras (HTS). As interest rates rise, the value of their portfolio of mortgage backed securities falls. In addition, they have to deal with the difficulty of hedging changing duration. High leverage makes the effect even more pronounced. A steepening yield curve does have some minor positives for REITs in that prepayments fall and their interest margin grows. However, on balance, the negative effect rising interest rates have on their assets dominates. Increasing interest rates are not all bad, though. One big beneficiary of rising interest rates are the big holders of mortgage servicing rights (MSRs), like Nationstar (NSM) or Ocwen (OCN). As rates rise, prepayments fall and this extends the expected maturity of their MSRs, which increases their value.