Foreign demand for U.S. assets significantly affects interest rates
The U.S. Treasury measures foreign purchases of the U.S. financial assets through the Treasury International Capital (or TIC) report. Foreign demand for the U.S. financial assets helped push the 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, although 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 the 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.
Mortgage Rates stay steady in spite of the machinations of foreigners and the Fed
In February, foreign investors bought a net $167.7 billion of U.S. assets. While this number can be volatile, this is a big inflow. To put these numbers in perspective, at its peak, the Fed was purchasing $45 billion worth of Treasuries a month. As foreigners have changed their net purchases of MBS, and the Fed has reduced MBS purchases, mortgage rates have held remarkably steady as the origination business has gotten more competitive and margins have fallen.
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, then the REITs will certainly feel the pain.
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