2 Reasons Interest Rates Will Stay Low: What This Means for Annaly Capital Management and American Capital Agency

James Bullard. Photo: stlouisfed.org

What: Because Annaly Capital Management (NYSE:NLY) and American Capital Agency (NASDAQ:AGNC) borrow based on the federal funds rate, an increase in short-term interest rates would raise their cost of borrowing, negatively impact profitability, and put pressure on the all-mighty dividend.

Over the past six months, the two companies have been all ears trying to decode the Federal Reserve's "yes, maybe, eventually" statements about raising interest rates.

On Monday, the two companies got a little more clarity on the situation from the President and CEO of the Federal Reserve Bank of St. Louis, James Bullard. He suggested, "The Federal Open Market Committee (FOMC) is "much closer to its goals than at any time in the past five years." 

Bullard went on to ask the inevitable next question, "If the FOMC is relatively close to its objectives," why are interest rates still so incredibly low?

To which he gave two reasons:

1. Labor market weakness 
2. Low inflation

Unemployment gets most of the headlines, but the statistic alone doesn't paint the full labor market picture.

In fact, there are a slew of job market indicators which are equally important. For instance, number of part-time workers for economic reasons and job availability are both well below the healthier 2004 levels.

Secondly, inflation creates a Goldilocks scenario for the FOMC.

Too much inflation erodes the buying power of the dollar, but too little inflation and consumers aren't incentivized to borrow and make investments to grow the value of their money. Bullard suggested, as previously stated by the Federal Reserve, the "just right" PCE (Personal Consumption Expenditures) inflation target rate is 2% -- above where we sit today. 

So what: In Annaly's first quarter conference call, CEO Wellington Denahan noted that the "first quarter of 2014 was a mix of conflicting signals." Which started with Federal Reserve Chair Yellen suggesting that interest rates would be increased later this year.

In response, Annaly and American Capital Agency entered into a hefty amount of hedge contracts that squeezed earnings. Despite the cost, it was safe play to protect borrowing costs. To make matters worse, Chair Yellen would go on to amend her earlier statement with one that removed the timeline for increasing rates. Which, of course, lead to more expensive hedging adjustments for the two companies.

This is why Bullard's comments are so important.

For Annaly and American Capital Agency to be successful in an undoubtedly difficult environment, the companies will need clarity from the Federal Reserve. And Bullard's comments were very similar to that of Chair Yellen and comments made by the CEO of the New York Fed Dudley last month. 

Now what: Bullard, not surprisingly, didn't put a timeline on when interest will rise. We'll have to wait for more answers on that later this month during Chair Yellen's quarterly news conference.

However, despite comments that the FOMC is close to its goals, it's unlikely there will be enough labor market improvement to warrant significantly raising interest rates in 2014.

Therefore, since Annaly and American Capital Agency are likely to reduce short-term hedges, the companies are in a good position to take take advantage of lower borrowing costs which should, if nothing else, protect the two companies' hefty dividends for the time being.