This Funny Speech Could Have Serious Consequences for ARMOUR Residential REIT and American Capital Agency

President of the Dallas Federal Reserve spoke recently about why interest rates should be increased. Here's what that could mean for ARMOUR and American Capital Agency.

Jul 18, 2014 at 9:59AM

Because mortgage real estate investment trusts have historically performed poorly in rising interest rate environments, ARMOUR Residential REIT (NYSE:ARR) and American Capital Agency (NASDAQ:AGNC) investors have been comforted by the Federal Reserve suggesting interest rates are likely to stay low for the next year, or perhaps longer.  

Richard Fisher Dallas Fed Pic

Source: Dallas Fed.

But in a speech on Wednesday referencing "beer goggles", how systemically important financial institutions, or "SIFI," sounds like a venereal disease, and included comparisons between monetary policy and duck hunting, the president of the Dallas Federal Reserve, Richard Fisher, explained that allowing interest rates to stay low for too long could cause a recession. 

Fisher concluded his speech suggesting he will argue for interest rates be increased in early 2015, rather than the Federal Open Market Committee's current consensus of mid-to-late 2015. The difference may seem small, but it could make a huge difference for ARMOUR and American Capital Agency.

Why interest rates should be increased
The Federal Reserve has suggested it will gradually increase the federal funds rate, or short-term interest rates, when inflation is stable at 2% and we reach maximum employment. 

While "maximum employment" is difficult to define, the labor market has made enormous strides. According to Fisher, the unemployment rate (6.1%) is six-months ahead of schedule, nonfarm payroll employment growth has been strong, and "quits" has been trending upward, suggesting workers are confident they will find new, or better, jobs.

Moreover, if unemployment is due to lack of necessary job skills or educational shortfalls -- and considering many of today's fastest growing careers require higher education, there is evidence to support this -- no amount of bond buying or interest rate manipulation will improve employment.

On the inflation front, Fisher said it's "clearly rising toward our 2% goal more quickly than the FOMC imagined." While some believe allowing inflation to run above the target will give the labor market an extra boost, Fisher explained that "tightening monetary policy once we have pushed past sustainable capacity limits has almost always resulted in recession." 

Lastly, Fisher echoed comments made during the FOMC's June meeting noting that extremely accommodative monetary policy (aka, super low interest rates) encourages excessive risk taking. Ultimately, Fisher believes that the Federal Reserve has crossed the line from "reviving markets to becoming the bellows fanning the flames of the "Booming and Bubbling."

Now what? 
Whether interest rates rise in early 2015, late 2015, or sometime after that, it will happen. This is an inevitability ARMOUR and American Capital Agency have been preparing for by adding a ton of hedges -- or, locking in borrowing costs by trading their floating interest rates for fixed rates.  

But both companies' are still exposed on the asset side. When long-term interest rates rise, it reduces the market value of ARMOUR and American Capital Agency's currently held fixed-rate securities (their largest asset class). Since mREITs trade based on the value of their assets, there would be a drop in both companies' stock price. 

Historically, the fall in stock price has mirrored the rise in mortgage, or long-term, rates. Because long-term rates are market driven, rather than being controlled by the Federal Reserve, a change in the current "path of policy" could cause market panic, and lead to volatility and sharply rising rates. This could potentially mimic the "taper tantrum" witnessed in 2013, a year in which ARMOUR and American Capital Agency generated dismal total returns of -35% and -29%, respectively. 

The good news is despite President Fisher's compelling arguments, his opinions remain within the minority. If the labor market and inflation continue to improve at an accelerated pace, however, that might change.

With that in mind, I do not see now as an attractive time to buy. But for long-term investors willing to ride out the adversity, I like American Capital Agency's stronger track record over ARMOUR.

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Dave Koppenheffer has no position in any stocks mentioned. The Motley Fool has no position in any of the stocks mentioned. 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.

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