NLY shares have had an important inverse relationship with the 10-Year Treasury yield lately.
The yield has at critical times, however, risen in a counterintuitive fashion.
I believe investors in NLY are wise to keep a keen eye on the yield and the geopolitical dynamics behind it for forward guidance.
In a recent article, I suggested Annaly Capital (NYSE:NLY) should benefit from a flight to quality on Crimea tensions. It's because interest rates are expected to decrease when demand for treasuries increases, which is what occurs during a flight to quality. Obviously, because of its portfolio of mortgage-backed securities, Annaly's book value is highly sensitive to such changes, and so is its stock price. However, as the days passed after I published my work, I noted a different dynamic than detailed in my analysis that has played the key role in the performance of Annaly Capital and many of its mortgage REIT peers these past couple weeks. It was the initial unexpected steepening of the yield curve and the surprising increase in the 10-Year Treasury rate. The 10-year yield has been a nearly perfect predictor of the change in NLY shares; it's just that it sent them downward rather than upward. I suggest Annaly holders watch the curve carefully for direction, and more specifically, the change and direction of the 10-Year Treasury Yield. Annaly's price performance has been inversely related to changes in that rate. Before long, I expect a wake-up call will be delivered to indifferent traders regarding the seriousness of the Crimean Crisis, and that might set things straight with regard to the relationship between the issue, the 10-year and Annaly. But there is a certain geopolitical dynamic that may be causing the steepening in the curve that should likewise be watched in order to predict where NLY might travel in the future.
When the incursion into Crimea began, I authored an article suggesting that Annaly Capital should benefit from a flight to quality. It was a common sense call recognizing the importance of the interest rate factor on the MBS packed mREIT.
The table here compares the daily yield of the 10-Year Treasury Note with the closing prices of Annaly Capital, American Capital Agency (NASDAQ:AGNC) and Market Vectors Mortgage REIT ETF (NYSEARCA:MORT). You will note the very reliable inverse relationship between Annaly's stock price and the interest rate on Treasury Notes. On days when the yield moved significantly higher, NLY and friends moved sharply lower. On days when the yield moved significantly lower, NLY moved higher. It's to be expected because of the MBS portfolios held within these firms. Changes in the MORT security are diluted due to the inclusion of so many component securities within it.
But while Russia was violating Crimea, we would have expected a flight to quality to drive all treasury yields lower. I believe the 10-year moved higher on lighter demand for it despite increased demand for shorter-term Treasury Bills. Market sentiment over the past two weeks has reflected a brushing off the geopolitical crisis. It is my view that greed allowed traders to allow some "friendly" commentary from Putin to guide trading. Is that well advised really?
Meanwhile, Russian legislators have cleared the legal path at home to annex Crimea, and this week, Crimea's Parliament voted for its independence from Ukraine. In a few days, Crimea will hold a popular vote on the same issue. All signs point to Russia's full occupation and likely annexation of Crimea. Such a scenario will certainly draw ire from Kiev and likely fire as well from a proud people. When blood is shed and war is begun, all bets are off and anything is possible. It would be a wake-up call for a complacent market, and it would drive the SPDR S&P 500 (NYSEARCA:SPY) darkly lower, send yields downward and NLY higher. Or would it?
I propose that one possibility for the weird action of the 10-year yield may be because the 10-year outlook for the U.S. is not definitely a secure one. This is because this geopolitical crisis pits Russia opposed to the United States. Thus, in this case, it is reasonable to question whether 10-Year Treasuries truly represent "quality" or a safe haven. Take note that gold and its equivalents and derivatives have moved more surely higher. I believe gold and the SPDR Gold Trust (NYSEARCA:GLD) still represent the ideal hideout for safety seekers.
How could Russia harm us?
The President has talked tough but not threatened military intervention in Ukraine. The last thing the world needs is a war between Russia, Europe and the United States. Putin is probably betting on that. So President Obama refers to "costs" that would be inflicted upon Russia through sanctions. This ignores the damage the former KGB man Putin could do us in return for such a blow. There are many legal and other means available to Russia to do damage to both the euro and the dollar, and those are being ignored by most in the popular press these days. I will not delve into the shady possibilities with regard to cold-war like tactics, but be sure to consider them on your own. However, I believe smart money gets it and perhaps is not buying the 10-year as would be expected under these circumstances.
Still, there was healthy demand for the latest offering of T-Notes, and treasury rates, even for the 10-year, are on the decline now. Thus, it would appear my initial article favoring Annaly Capital here on the flight to quality impact to rates, which in turn lifts Annaly's book value, is supported finally. Just beware that if the United States gets too involved and Russia counters in some damaging way to the dollar or the U.S. economy, the safe haven appeal of the U.S. treasuries could be voided. In that case, we would see rates rise and capital would flock even more heavily into gold. So, you can see why I say you Annaly holders are well advised to keep a close eye on these matters.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.