I've always said that Annaly Capital Management's (NYSE:NLY) income generation will suffer as the yield curve flattens. A flattening yield curve has been the trend as short-term rates have increased at a much more rapid pace than long-term rates thanks to recent rate hikes. While the cause of a subdued tail is a mystery to me, it is what it is. The curve will either be steep enough for Annaly to earn a decent spread or it won't, and thus far, it looks like it will not (read Annaly's Business Model Is In Jeopardy).
Despite my pessimism, the stock has remained buoyant thanks to its book value, supported by a persistent decline in long-term rates. Still, I believe that it is just a matter of time before the existing portfolio runs off and new money gets invested at lower spreads, pressuring funds generated from operations (i.e. not from capital gains). Recently, there seemed to be a shred of hope however.
Fed To The Rescue
While much of the attention on the Fed's policies has revolved around the increase in the federal funds rate, recently there has been more discussion regarding the Fed's plan for long-term rates, which as we know, will have a huge impact on Annaly's future profitability. It is no secret that the Fed did multiple rounds of quantitative easing to push these rates down.
Now that the Fed is becoming increasingly more optimistic about the economy (as evidenced by the rate hikes), it is getting closer to "unwinding its balance sheet." Theoretically, the act of unwinding would increase the supply of long-term bonds and thus increase the yield, which should allow Annaly to maintain a healthier spread, and in turn, a healthier dividend.
Similar to my view of future rate hikes, this is really a one-way street here. It must be accepted that the Fed will not perform another around of QE, hence incremental pressure on long-term rates should only be positive (i.e. sending them higher). While this may erode Annaly's book value in the short term, I believe that such a scenario would be beneficial for a significant portion of the investor base, as Annaly's dividend is the main attraction.
Market Takes Hope Away
Given the above, you would think that the market will act well in advance of the actual "unwinding." Unfortunately, for Annaly investors, this admittedly sound argument has failed to play out: Long-term rates have failed to recover significantly despite the revelation from the minutes that most market participants are expecting a change to the Fed's reinvestment policy (i.e. starting to unwind the balance sheet) later this year.
Take a look at the graph below:
The small bump towards the end is the result of the election as the market bakes in higher inflation expectations under the Trump administration. We can see that long-term rates have since been range-bound. For whatever reason, the market is not giving any credence to the Fed's firepower.
No matter the reason, the present situation (side-way long-term rates, climbing short-term rates) is probably the worst -case scenario for Annaly. The spread will not only shrink, the company will also fail to gain any benefit from capital appreciation as the result of the decline in long-term rates.
Is there any silver lining here? I suppose that one could say that the market is underplaying the potential impact of the Fed unwinding its balance sheet. But if we were to think that the market is somewhat rational, why would the market doubt the Fed firepower? After all, it was the Fed that did rounds of QE to push rates down in the first place! The most logical conclusion would be that a reversal would have the opposite effect.
While we can speculate all day as to why long-term rates are not rising significantly, ultimately, the value of Annaly depends on the current curve. So unless the market changes its mind soon, I will remain bearish on the stock.
Disclosure: I/we 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.