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Recommendation: How to play the REITs now that we have a deal

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Updated

The most lasting effect of the shutdown was probably in the Fed

Many people in Washington were highly disappointed that the markets yawned at the government shutdown. They were hoping that a violent reaction might force Congress to get together and find some common ground. It didn’t happen, although the polling data was enough to get Republicans to relent and accept a re-opening of the government without any changes to Obamacare.

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The big effect, however (and this is why the markets rallied so much on the news), is that the Fed is probably on hold for the rest of the year. Bonds sold off dramatically in spring on speculation that Ben Bernanke was going to start ending quantitative easing. This move has been very tough on the REITs, as they have had to take mark-to-market losses on their portfolio assets, and REITs that are in the origination business have seen activity dry up as the low-hanging refinance fruit has been taken away.

Has the macro story changed for the REITs?

Overall, the macro story hasn’t changed—it has only been delayed. Interest rates are going up. Take a look at the above chart to get an idea of how long interest rate cycles are. REITs may have been given a bit of a reprieve, but quantitative easing is going to slow and end eventually. What could change things? The Fed has said that it will be guided by the economic data—particularly the employment data. If we get a jump in the unemployment rate, or a bad jobs report on Tuesday (think sub-100k jobs), then the Fed will probably maintain policy.

However, there’s one other data point it’s watching, and that’s the real estate recovery. In the minutes, it discusses how the real estate market is behaving, and real estate activity clearly figures in its thinking. We’ve seen the West Coast market begin to cool and housing starts have backed off after hitting a 1 million unit pace earlier this year.

If the real estate market rolls over, the Fed will probably find any excuse it can to keep quantitative easing going forward. If that happens, switch out of the non-agency REITs like PennyMac (PMT) and Two Harbors (TWO) and into the agency REITs like Annaly (NLY), American Capital Agency (AGNC), and MFA Financial (MFA).

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