As you may have heard, Federal Reserve Chairman Ben Bernanke gave an important economic update to Congress on Wednesday and Thursday. While Bernanke said he expects economic growth to continue at similar rates to what we saw toward the end of 2011, it's what he didn't say that's important for high-yielding mortgage REITs.
He didn't hint at further monetary easing such as QE3 coming down the pike. That's not to say it won't happen. But with the Fed expecting no big employment gains for the rest of the year, failure to mention such a program indicates that if a third round of quantitative easing does happen, it'll happen later than we might have expected.
What does all this mean? The Fed is really playing it safe on inflation -- perhaps on account of the temporary spike we've seen in energy prices. By delaying further easing, it's tolerating high unemployment for years to come, despite the fact that core inflation is actually below its 2% target. Given how many jobs were lost during the financial crisis and recession, it'll probably take at least another four to five years before we climb back to full employment.
All of this is great news for residential mortgage REITs. The Fed's reticence to pursue further easing means the picture for long-term rates is looking better.
One of the big risks hanging over residential mortgage REITs has been the possibility that further easing by the Fed would push long-term rates down further. Indeed, over the past year, Hatteras' interest rate spread has fallen from 2.26% to 1.78%, Armour Residential's (NYS: ARR) spread has fallen from 2.88% to 2.18%, and Annaly Capital's (NYS: NLY) spread has fallen from 2.08% to 1.62%.
Even Two Harbors (NYS: TWO) and Invesco (NYS: IVR) , which have a bit more flexibility than the pure agency REITs, have seen their portfolio yields and interest rate spreads decline. American Capital Agency and Chimera (NYS: CIM) seem to have weathered the shrinking spreads a bit better than most so far. Depending on the specifics, Chimera may have the best chance to dodge the bullet given just how extreme its portfolio flexibility is, but declining long-term rates threaten to reduce the profitability of the mortgage REIT model by quite a bit, despite their strategic differences.
In short, the spread decline is a big deal.
Annaly Capital's chief operating officer put the dynamic this way in the company's most recent conference call:
There's no question that the Fed has done a good job of engineering a flatter curve and spreads. I don't care who you are. Spreads have come in for everybody, and you don't get protection without a price. So we continue to balance between all of the options that the market has to offer.
But Bernanke's big speech this week indicates that these high-yield REITs might not see their spreads come down quite as quickly as we might have thought, which gives REITs a little more room to use leverage, and could lengthen by a bit the medium-term period over which investors will get to enjoy those high yields.
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At the time thisarticle was published Ilan Moscovitz doesn't own shares of any company mentioned. The Motley Fool owns shares of Annaly Capital Management and Chimera Investment. Motley Fool newsletter services have recommended buying shares of Annaly Capital Management. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.