Sovereign yields have been rising since the beginning of May
Investors in the U.S. have been focused on the rising yield of the 10-year bond since the beginning of May. Since bottoming out at 1.63% on May 1st, the U.S. 10-year yield has been rising in a dramatic fashion, to close at 2.17% as of May 28th, a 54 basis point jump in a little under a month. This has pushed the average 30-year mortgage rate from 3.4% to 3.88%, which has more or less stopped the mortgage refinance boom dead in its tracks.
Conventional wisdom for the move
There have been a few narratives used to explain the move, which mainly revolve around quantitative easing. First, there was the April jobs report, which came in better than expected, but was by no means a report you would see in a normal economy, let alone a robust expansion. Second, there was Ben Bernanke’s testimony last week, where he refused to rule out tapering quantitative easing by Labor Day. Many in the market have taken that to mean the Fed plans to do so. However, his statements could also be interpreted as, “I am going to follow the data and not rule anything out.” Finally, the recent strength in both the equity and housing markets have been pointed to as another catalyst for the Fed to taper.
Falling for the wrong reasons?
The “It is all about the Fed” explanation would make more sense if other sovereign bond yields were not behaving the same. However, pretty much all of the main economies – Japan, the US, the UK, and Germany – all started falling about the same time. Japan’s swoon is even more remarkable given that the Bank of Japan had recently announced its own quantitative easing program. One would expect a Japanese Government Bond (JGB) rally on such an announcement, but instead investors are selling JGBs. The fact that yields are falling worldwide and more or less at the same time, indicates something else is going on.
A couple possibilities for the move could be (a) receding fears about a European contagion, and (b) a global “risk on” trade. Given that the yields of Portuguese, Spanish, Italian, and Irish bonds have dropped so much over the past year indicates that the market has pretty much dismissed the prospect of a European contagion. Global investors may be selling low yielding sovereigns, like the U.S. and Japanese bonds, to purchase higher yielding assets.
Another (related) explanation is the global “risk on” trade. The bond markets may be sensing a turnaround in the world economy, taking cues from rallying global stock markets. While either explanation could be right or wrong, the fact that global yields are rising together indicates it is a global phenomenon, not the market parsing Ben Bernanke’s FOMC minutes.
Implications for mortgage REITs
The sell off in U.S. Treasuries has taken a toll on mortgage REITs. The Mortgage REIT ETF (MORT) is down 10.4% since Treasuries started selling off. Annaly (NLY) is down 12%, American Capital (AGNC) is down over 20%, and even ARM mortgage investor Hatteras (HTS), which should have much less interest rate risk than the other REITs, is still down 5.6%.
While a steepening yield curve is generally positive for mortgage REITs, because the difference between their cost of borrowing and the return on their assets increases, they also suffer mark-to-market hits as the value of their holdings decline. Since most mortgage REITs are highly levered, a sell-off of this magnitude can wipe out much of the interest they make. Finally, mortgage investors are vulnerable to interest rate shocks, and the stock prices of these REITs shows they are being felt.