Our main concern has been what action, or inaction, the Federal Reserve will take at their meeting Tuesday and Wednesday. Ben Bernanke has a solid majority on the board, so even though there were three dissenting votes to extend low interest rates through 2012, he can probably do what he wants.
What does he want to do? According to Reuters, he told an audience in Minneapolis two weeks ago the Fed “will do all it can to help restore high rates of growth and employment in a context of price stability.”
It is widely viewed that QE3 is off the table (for now). That leaves the widely discussed “operation twist.” Operation Twist was last done in 1961 to lower long term interest rates. In QE1 the Federal Reserve bought $1.8 trillion of mortgage backed securities (MBS) and short term treasuries. In QE2 the Feds bought $600 billion of short term treasuries.
Operation Twist involves the Federal Reserve buying long term treasuries (10 to 20 year). The Fed has about $35 million in short term debt refunding each month and it has already told us it was going to reinvest it in more treasuries. The market has always assumed these purchases would be short term as this presents the least interest rate risk to the Fed.
We expect it to announce its buys in the future will be in long-term treasuries which will force long term interest rates down even more - tightening the “spread” between short term rates and long term rates.
This won’t help the housing market as mortgage rates are already at historic lows; one more percentage point lower won’t make people buy what they don’t want. But, it will hurt the margin "virtual banks" make in their operations.
Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) make money buying mortgage backed securities (long term) and borrowing money short term. They then lever their balance sheets up to eight times and pay shareholders a handsome dividend. You can see how they can get squeezed.
We also have the matter of the SEC opening a “concept release” on REITs continuing status under the Investment Company Act of 1940. This should be completed in 60 days.
NLY and AGNC are both trading close to their 52-week highs. Is it just me or does it seem like REITs that make money on interest rate spreads might have some rough water in front of them?
It seems prudent to sell AGNC and NLY until we understand how their operations can be affected. We may come back to them once we have a better feeling for potential SEC action and see the ramifications of Fed action. We will miss out on the coming dividends, but by ex-date it may be too late to get out with the nice capital gain you may have now.
Before market open Wednesday we will enter these orders:
AGNC--$trailing stop $0.15 GTC
NLY---$trailing stop $0.10 GTC