For Mortgage REITs like Annaly Capital Management and American Capital Agency Corp, Short-Term Interest Rate Panic Looms


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When the Federal Open Market Committee released the minutes of its June meeting, markets learned two things, neither unexpected. One had to do with the exit from bond purchasing pursuant to quantitative easing, which the committee stated would end in October of this year. The other reiterated its longer-term plan to keep the federal funds rate at its current level of zero to one-quarter percent for the foreseeable future. 

Markets barely responded, and mortgage REIT bellwethers Annaly Capital Management, (NYSE: NLY  ) and American Capital Agency Corp. (NASDAQ: AGNC  ) , as usual, had their fortunes lifted or depressed by the movements of the 10-year Treasury bonds.

Whispers begin
It didn't take long, however, for various Federal Reserve Bank presidents to start voicing their opinions on the fate of short-term interest rates. The subject has been brought out into the open following the June employment report, which showed a gain of 288,000 jobs, and a dip in the unemployment rate to 6.1%.

A hike in the federal funds rate would mean a world of pain for mREITs, which thrive upon the spread between the short-term rates at which they borrow and the long-term rates of the mortgages contained within the securities they buy. Increasing borrowing costs is huge for these trusts, and investors can't be looking forward to the day when this aspect of monetary policy gets put into practice.

How soon?
Several Fed presidents have spoken out thus far. Recently, hawkish Philadelphia Fed chief Charles Plosser told The Wall Street Journal that the economy is brightening to the point that keeping short-term rates abnormally low could be detrimental, rather than positive. Kansas City Fed President Esther George told a business group in Oklahoma that "a lifting off of zero" could happen by the end of this year, in her opinion, according to economic indicators used by the Fed to determine changes in monetary policy.

On the other hand, Chicago Fed President Charles Evans and Atlanta chief Dennis Lockhart both see short-term rates staying low at least until mid-2015, noting that the FOMC needs to feel secure that the economy can support price stability. Evans also commented on the fact that the labor participation rate is still at an all-time low.

There's no way of knowing, of course, whether the hawks or the doves will prevail, but that's not really the issue right now. As we have seen in the not-so-distant past, the fear of any upward trend in interest rates – whether of long-term rates or short-term – can have a devastating effect on mREITs.

The taper terror was the cause of most of the sector's upheaval last year, and Fed Chair Janet Yellen's now-famous "around six months" phrase in regards to a rise in the federal funds rate caused another rout this past spring, when both Annaly and American Capital Agency tanked following that comment.

Although the worries over the taper finally settled down, the hiking of short-term rates is a biggie, and jitters over its effects could result in some serious damage to the mREIT sector. Unfortunately, this scenario is almost certain to occur. For investors who keep this in mind, though, the coming storm will be much easier to withstand.

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