For bank investors, the changes in today's interest rate environment simply cannot be ignored. I expect interest rates to become increasingly volatile over the next 6 to 12 months, and this volatility will present buying opportunities in high-quality mortgage companies caught up in short-term market movements.
The tides of interest rate change began in May as rates began to move skyward, and the climb continued through the summer. The Federal Reserve is currently the main driver of interest rates, and the markets are on edge waiting for the outcome of next month's meeting of the Fed's Federal Open Market Committee (FOMC) to decide the short-term future of U.S. monetary policy.
Why I do expect volatility in interest rates
First, many of today's monetary policies have never been tried before, at least not on the scale we have today. As such, the markets have no precedent to study and no prior experience to guide expectations. What will happen next is anyone's best guess.
Beyond that, many economic indicators provide conflicting or unclear direction for the economy. GDP is growing, though at just less than 2% in the second quarter, it remains sluggish. Unemployment is steadily improving, but problems remain in the youth demographic and for long-term unemployed individuals.
The real estate market is showing signs of improvement, with home sales and values rising impressively over the past two years. But at the same time, Wells Fargo Economics reports that as of the first quarter, 19.8% of all mortgage loans in the U.S. are underwater with loan balances higher than the value of the house.
Today's reality is that the Fed is in uncharted territory, deciding when and how to unwind novel policies on an uncertain and confusing economic landscape. When the markets are left guessing, volatility ensues.
Third, members of the FOMC have been, well, confusing in their recent public statements.
Ben Bernanke, Chairman of the Federal Reserve, has been back-peddling all summer after appearing too aggressive in tapering the Fed's policies in remarks following the May meeting. He's been joined by other like-minded FOMC members, notably Janet Yellen (more on Ms. Yellen in a moment).
On the flip side, Richard Fisher, president of the Federal Reserve Bank of Dallas -- and currently not a voting member of the FOMC -- was quoted just last week in the German newspaper Handelsblatt as saying that the Fed "should begin reducing bond purchases in September, as long as we don't see a clear worsening of the economic data." Charles Evans, president of the Federal Reserve Bank of Chicago, made similar statements the week before, albeit with a bit more nuance than Fisher.
Adding to the uncertainty, Mr. Bernanke's tenure as chairman of the Federal Reserve will be ending in early 2014. Most of the "in the know" commentators anticipate either Larry Summers or Janet Yellen to be the next chairperson, though no one outside President Obama's inner circle knows which of the two has the inside track.
With so much uncertainty, it's worth repeating: When the markets are left guessing, volatility ensues.
For the mortgage industry, the stakes are high
Low interest rates had been fueling a boom in mortgage refinancing -- a boom that contributed billions in origination fees to the likes of Wells Fargo (NYSE:WFC). But that boom has cooled seemingly overnight at just a hint of rising rates.
With 26% of second-quarter non-interest revenue coming from its mortgage business, a slowdown of this scale could seriously dampen earnings at Wells while the rate environment attempts to find some stability.
This would only be a short-term issue, though, as higher rates will benefit the bank in the long term by providing higher yields. Remember, bank income is based on the interest rates for loans. Higher interest rates mean higher income in times of stable rates.
Beyond banks, the mortgage REIT sector has been hit particularly hard this summer thanks to the rate environment. Companies like Annaly Capital Management (NYSE:NLY)and Invesco Mortgage Capital (NYSE:IVR) have been sent to lows nearing 40% from each company's 52-week high, driven by tightening interest rate spreads and declining book values.
Annaly has been hard at work over the summer, increasing its interest rate hedges to now cover 92% of its investments, selling $32 billion in assets to reduce risk on the balance sheet, and otherwise restructuring the portfolio to better perform in a volatile interest rate environment.
Invesco, like Annaly, has the advantage of being a hybrid REIT, meaning it can invest in securities not issued by either Fannie Mae or Freddie Mac. On the companies' second-quarter earnings call, CEO Richard King highlighted increased interest rate hedging, diversifying into commercial securities with attractive yields, and improving the companies funding strategies in anticipation of further volatility.
A common theme
The vast majority of investors and market observers recognize that interest rates will rise from today's historically low levels. The uncertainty is when and how rates will move from low to high.
Unfortunately for my bank account, I don't have a crystal ball to see the future in the markets. But I do recognize the uncertainty today, and to me, that indicates volatility. When faced with these challenging conditions, I want my investing dollars in companies that are fundamentally sound and capable of weathering the storm.