The shape of the yield curve matters almost as much as the absolute level of interest rates to financial companies
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. While there are many different ways to measure the steepness of the yield curve, the twos/tens spread – or the difference between the yield on the 10-year bond and the two year bond – is one of the more popular ways to do it.
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 couple of weeks, a number of strong economic reports have caused longer-dated bonds to sell off (interest rates to rise) and pushed equities higher. In addition, better-than-expected first quarter earnings have increased investor appetite for stocks. Market participants normally refer to this effect as the “risk-on” trade. Conversely, the “risk-off” trade is characterized by a rally in bonds (falling long-term rates) and a sell-off in stocks. The strong jobs report of Friday, May 3rd started the sell-off. Since then, we have had lower-than-expected initial jobless claims and better consumer spending. As the S&P 500 continues to hit new highs, investors are rotating into stocks.
Implications for the mortgage REITs
A steepening yield curve is a double edged sword for mortgage REITs, like American Capital (AGNC), Annaly (NLY), or Hatteras (HTS). On one hand, as yields rise, it means that the price of their assets is decreasing, which gives them mark-to-market losses. On the other hand, it means that their interest margins are increasing, which bolsters their profitability. Remember, the REITs borrow short and lend long. Their cost of funds stays the same, while the yield on their investments rises. Increasing interest rates also means prepayments slow down. This helps the REITs, especially agency REITs. 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.