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Bonds rally on Fed rate decision

The Federal Open Market Committee determines interest rate policy

The June Federal Open Market Committee (FOMC) meeting was recently completed and the results of that meeting were released at 2:00 pm EST. The FOMC statement sheds light on how the Fed views the economy, how they are thinking about moving forward, and some guidance regarding their intentions. After the release, Ben Bernanke usually holds a press release where he takes questions. This is a first from a Federal Reserve Chairman. In many ways, Bernanke is the polar opposite of Alan Greenspan, who preferred to be as inscrutable as possible.

10 year bond yield - LTEnlarge Graph

The statement and what has changed

The market went into the statement uncertain as to the timing of  the end of quantitative easing (QE). Ever since the prior FOMC meeting, the market has accepted that QE will end sometime next year, and the Fed will probably start tapering purchases this year. Since then, yields have increased markedly, and the 10-year bond has been trading in a range of 2.55% – 2.7%. So, the biggest question, which is “September or December?” largely went unanswered.

This statement was considered to be relatively dovish. The Fed did not address tapering directly, in fact, they stated they stood ready to increase or decrease purchases as economic data warranted. They reaffirmed their forecast that economic growth will accelerate into the end of the year (given that Q1 GDP was revised downward by a lot, it makes one wonder what the Fed is looking at). Finally, they inserted language that expressed concern about disinflation – that the Fed could be failing at both of its dual mandates – keeping unemployment low in the context of low inflation. This language was enough to bring one of the previous dissenters back into the fold.

Of course all of this is happening in the context of a new Fed Chairman at the end of the year. Right now, it is a horse race between Fed Vice Chair Janet Yellen and Larry Summers. Janet Yellen is considered to be more dovish than Bernanke, while Summers has expressed skepticism over QE. So it is not out of the question that tapering could begin this year, only to have the process reversed (or accelerated) by a different Federal Reserve Chairman.

Implications for mortgage REITs

It has been a rough six weeks for mortgage REITs, like American Capital (AGNC) and Annaly (NLY), who have a concentration of 30-year fixed rate mortgage backed securities. The backup in rates has taken a toll on the value of their assets and their stocks have performed poorly. Agency REITs that focus on adjustable rate securities (ARMs), like MFA Financial (MFA), have performed better, but are still down. REITs that have exposure to mortgage servicing rights (MSRs), like Nationstar (NSM) and Ocwen (OCN), have rallied substantially since rates have increased.

The takeaway is to expect more of the same. Even since the bubble burst, the yield curve still isn’t all that steep. Also, not all REITs react to increasing interest rates the same way. Some will benefit from increases while others will get hit hard.

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