Where's the Market Headed for the Fattest Dividend Sector?

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Investors in mortgage REITs such as Annaly Capital (NYSE: NLY  ) need to keep a sharp eye on the larger economy and, in particular, moves by the Federal Reserve. As long as interest rates remain depressed, the mortgage REITs should continue to pump out their double-digit dividend yields.

With that in mind, it's useful to have a look at some of the latest Fed language, as well as Annaly's own quarterly update on the market.

The Fed speaks Fedspeak
The market seemed to react positively to the Fed's announcement last week, interpreting Ben Bernanke's statement before Congress as saying that Quantitative Easing 3.0 was in the offing. While Bernanke acknowledged that economic weakness could persist, he also enumerated the ways in which the central bank could tighten monetary policy in a stronger economy, eventually leading to more conventional Fed operations. 

I found Yves Smith's gloss from Naked Capitalism the most reasonable:

The Fed will pause to assess the economy before doing anything else. If economic growth in the U.S. does not falter in the second half of 2011, the Fed will look to drain excess reserves from the system as preparation for an interest rate hike at some unforeseeable future date. … Bottom line: There will be no stimulus unless the economy and/or asset markets deteriorate further.

As the Fed takes a wait-and-see approach, plenty of indicators show that the economy is not improving, including persistently high unemployment. That should augur for low rates and more Fed intervention. And that stagnant or deteriorating climate should continue to be beneficial for Annaly and other mortgage REITs such as Chimera Investment (NYSE: CIM  ) and American Capital Agency (Nasdaq: AGNC  ) , among other players. Indeed, that was a huge rationale for my purchase of Annaly shares for my Special Situations portfolio.

Mortgage REITs are heavily reliant on their rate spreads, which they then lever up to achieve those gaudy returns and yields.

Company

Rate Spread, Latest Quarter

Rate Spread, Year-Ago Quarter

Annaly 2.17% 2.22%
Chimera 5.41% 5.54%
American Capital Agency 2.58% 2.16%
Armour Residential (NYSE: ARR  ) 2.40% 2.68%
Cypress Sharpridge (NYSE: CYS  ) 1.83% 2.72%

Source: Capital IQ, a division of Standard & Poor's.

And so economic conditions that permit low rates should continue to benefit these companies, allowing them to maintain or perhaps increase their rate spreads.

Annaly speaks
Annaly's release provides some key insight into management's thinking and further corroborates my investing thesis. The report begins, "There was a marked deterioration of economic indicators in the second quarter, followed by downgrades of current and future quarterly GDP estimates by the Federal Reserve (the Fed) and private forecasters." Those downgrades show that things are not moving in the right direction.

On jobs, Annaly stated: "The June 2011 report was unambiguously bad (labor force and participation rate down, hourly earnings down, work week down, temp workers down, average duration of unemployment up, etc.) and a big disappointment for those hoping that the poor May report was a single hiccup in an otherwise strengthening recovery. What we saw was a serious loss of momentum in the economy." Again, that's ultimately a positive signal for mortgage REITs, since it means that interest rates should still remain low.

And then Annaly predicts what should be the likely next stage in clearing up the financial morass that encompasses much of the world:

It is no wonder that when the Fed ends QE2, we see slouching economic data and falling inflation expectations. The Fed and Treasury are not natural buyers and holders of household and financial sector obligations, so the restructuring will need to continue into its next phase: the re-privatization of risk. The markets will eventually need to learn to price risk correctly. … We suspect that the transition to the next stage of restructuring in the U.S., and the eventual restructuring of the debt built up by European peripherals, Brazilian households, and Chinese local governments will not be without pain.

Foolish bottom line
Annaly's quarterly market commentary suggests that there's plenty of hurting to come for the economy. And that's one of the reasons I think Annaly can make a great hedge to an otherwise diversified portfolio. You can read more about my thoughts on Annaly as an investment.

This article is part of our Rising Star Portfolios series, where we give some of our most promising stock analysts cold, hard cash to manage on the Fool's behalf. We'd like you to track our performance and benefit from these real-money, real-time free stock picks. See all of our Rising Star analysts (and their portfolios).

Jim Royal, Ph.D., owns shares of Annaly. The Motley Fool owns shares of Chimera Investment and Annaly. Try any of our Foolish newsletter services free for 30 days. We Fools don't 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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