Foreign demand for U.S. assets significantly affects interest rates
The U.S. Treasury measures foreign purchases of U.S. financial assets through the Treasury International Capital (or TIC) report. Foreign demand for U.S. financial assets helped push U.S. interest rates to record lows last summer. Fears of a European contagion fed a flight to quality, which pushed the ten-year yield down to below 1.4%. While that sort of yield is certainly paltry versus what we’ve historically been able to earn on Treasuries, compared to the rest of the world, 1.4% was competitive. Now, as the Fed threatens to end asset purchases, foreign investors have been getting out of the way even though the Fed has said it doesn’t intend to sell its holdings and will even reinvest maturing securities back into the market.
The other driver of foreign purchases of U.S. 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 U.S. goods and services, or they can use the dollars to purchase U.S. financial assets. Large export-driven economies like China are more apt to run large trade surpluses, which means they’re forced to hold a lot of U.S. assets.
Foreigners get out of the way ahead of the end of QE and the government shutdown
Last month, foreign investors sold a net 106.8 billion of U.S. assets. While this number can be volatile, this is a big outflow. To put these numbers in perspective, the Fed purchases $45 billion worth of Treasuries a month. It has averaged about 25.7 billion a month over the past few years. So while foreigners do have an impact, the Fed is the 800-pound gorilla in the U.S. sovereign debt market. That said, if the Fed stops purchasing mortgage-backed securities and foreign investors continue to sell, that leaves de-leveraging mortgage REITs to pick up the slack. This could mean higher mortgage rates going forward—something the Fed is almost certainly going to monitor closely.
Given that the Fed had signaled that it would begin to reduce asset purchases last spring, and the market expected a September taper, it will be interesting to see if this reverses. The October numbers will include the shutdown, so we could see another big net negative number.
Implications for mortgage REITs
The absolute level of interest rates is a prime driver of mortgage REITs like American Capital Agency (AGNC), Annaly Capital (NLY), MFA Financial (MFA), Hatteras (HTS), or Capstead (CMO). Mortgage-backed securities closely track the level of long-term Treasuries—although they’re not quite as sensitive.
Falling mortgage-backed security prices hit mortgage REIT book values across the board. Nearly every REIT experienced a sizable drop in book value. The differences came between those that were highly leveraged and those with shorter duration. If foreign investors return to selling mortgage-backed securities, the REITs will feel the pain.
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