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Recommendation: Why swap interest rate risk for credit risk?

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How to position yourself after the November jobs report

The most important economic report these days came out last Friday, which is the monthly jobs report. The Street had set the bar relatively low, with a 183 thousand increase in payrolls forecast, along with a 7.2% unemployment rate. The economy ended up adding 203,000 jobs and the unemployment rate fell from 7.3% to 7.0%. Finally, the labor force participation rate ticked up, which marks one of the few times that the unemployment rate fell for the right reasons (more people working) and not for the wrong reason (lower labor force participation rate)

Labor Force Particiption Rate

The Fed wants to see a robust labor market before it makes any changes

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That said, an upside surprise of 200 thousand jobs or so probably isn’t going to make or break the Fed’s decision making. Don’t forget the Fed looks at the employment market holistically and isn’t about to pin the fate of QE 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.

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, their 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).

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