The economic data is coming in stronger than expected and the Fed is removing support
We have seen a number of strong economic reports, from the 4.1% GDP report, to industrial production, to decent jobs reports. The economy is clearly on the mend and the Fed acknowledged this fact when it decided to taper. This puts the income-oriented investor in a difficult situation: this is an unfriendly environment for bonds, and with the stock market at all-time highs, yield is hard to come by.
The Fed wants to see a robust labor market before it starts raising interest rates
It looks like the government isn’t going to renew the extended unemployment benefits, which means many long-term jobless will be forced to take a part-time job. This is probably going to reduce the unemployment rate a tad going forward. Should you worry?
Don’t forget the Fed looks at the employment market holistically and isn’t about to pin the fate of monetary policy solely on the unemployment rate—especially if it remains stuck at levels we haven’t seen since the Carter Administration.
A low labor force participation rate means wage growth will be hard to come by. It represents a “shadow inventory” of workers who would rather be working than not working. Employers know there’s this huge reservoir of experienced workers they can tap, and employees know it too. This means very little bargaining power for workers, which will keep a lid on wage inflation. And if there’s no wage inflation, there’s no wage-price spiral, which is the driver of inflation in the first place.
Stick with credit risk, not interest rate risk
REITs like Annaly (NLY), American Capital (AGNC), MFA Financial (MFA), Capstead (CMO), and Hatteras (HTS) sold off on the stronger-than-expected November jobs report. That said, the REITs are in a much better place as far as leverage than they were six months ago. Even if the Fed begins to taper in December, its stock prices are discounting this scenario, and the risk versus reward looks reasonable at these levels.
In this environment (increasing interest rates and a stronger-than-expected economy), it makes sense for income investors to focus on the non-agency REIT space—think names like Two Harbors (TWO) and Newcastle (NCT). While they have interest rate risk, they have less of it than the big agency names, and they benefit from improving credit. The agency REITs will be at risk from a Mel Watt FHFA as well, as prepayment speeds will probably increase—especially if the government extends the eligibility dates for HARP (the Home Affordable Refinance Program). That said, Mel just threw the originators a bone, by delaying Ed Demarco’s planned increases in conforming loan level pricing adjustments. On the other hand, this means higher prepayments at the margin for agency REITs.