How to Profit From Federal Reserve Rate

Don't you wish you had known, just before the housing bubble burst, where to put your money to take advantage the mayhem that resulted when the bubble went "poof"?

I do. I know people made billions from it.

This got me thinking, "what's next"?

I hear A LOT of smart people saying that interest rates are going to rise dramatically in the next 1 - 2 years, due to the massive amount of money that's been printed and the need to tame inflation that will result from it.

Even without all the talk of printing money and inflation, with current federal reserve rates currently at 0 - 0.25% it seems to be to be a pretty sure bet that they can only go in one direction, as I don't think quantitative easing will ever involve having countries pay for the privilege of lending the US money.

So in my little brain, it seems that a long term leveraged way to benefit from a rise in federal reserve rate would be a pretty safe investment. The only real risk is when they will go up, not if.

Is there a flaw in my logic? ... please chime in.

And more importantly, if my logic is decent, what specific investments can be used to directly take advantage of a rise in fed rates, preferably with leverage?

short treasuries. That is likely going to be a hugely profitable trade. But as you mentioned, the timing of a trade like that is critical. Who knows how long interest rates will stay this low. I doubt we will see an interest rate hike before next summer at the earliest.

I don't think interest rates can go up any time soon so there are ways to ride this yield curve for a while. MBS Reits- examples: WAC, NLY, CMO, ANH should go up in the rate environment. As the fed starts hinting that interest rates are about to go up, then short these same stocks.

I just finished selling all of my WAC today for just small profits. I might reenter, but the paper this company holds bothers me.

NLY, CMO and ANH hold mostly agency debt.... 12 month yield now at lowest EVER makes these stocks much more compelling. It's utopia for these companies now and as long as Fed keeps pressure on the rates, there will be plenty of beautiful divvys.

Do your own DD, but let me know if I can help. (I am very long all NLY, CMO and ANH)

PST and TBT -- they are Treasury Short ETF's.

I have been holding NLY and increasing my position for the past year. It is one of my top performers. I am sure the others are good too, but I try to keep a limit on my exposure to one industry.

I have traded a lot of TBT in the past but now I have a hard time understanding the short EFT since treasury yields are basically lowest levels EVER, yet the unit price of TBT is above it's low point achieved in October.... can someone explain that?

one would think at current yield levels, TBT would be hitting its all time low price per unit.

I don't know if shorting treasuries at this time is the way to go.... Swiss, Greece, Dubai all just this week alone announced upcoming defaults.

British pound is experiencing mass exodus.

Japan can barely keep its nose above water.

The European banking system leverage is too much for the Euro to handle.

Most of the world currencies cannot handle the sheer volume of funds like the US$ can and despite the debt load USA has currently, their risk of default is surprisingly lower than just about everyone else in the world.

What's left? BRIC? China keeps the yuan pegged to US$, Russia is too corrupt and unstable, not to mention hostile.

Brazil, China and India have probably best futures but their economies are fractions of the USA's.... and even combined, these currencies would never be able to handle amount of funds looking for a home as the US Treasuries have provided.

to take advantage of the current rate environment? this is probably one of the steepest yield curves in eons.

Last time this yield curve steepened, the MBS Reit sector hit the motherlode. There used to be dozens of companies, but today there's really only a handful and the best part? much of their risk is reduced because their exposure is largely GSE, Fed backed debt. It's nirvana.

Can I ask you to explain this a bit more, specifically what it means to an retail investor like me.

when talking "yield curve" it is the comparison of a long note vs a short note. Historically speaking, the yield of the 2 year vs the 10 year is what most financial analysts or economists use to forcast economic activity. Almost every single recession was predetermined by an inverted yield curve.

typically long bonds have higher rates than shorter bonds

during inverted curves, the short yields are actually higher than long.

plot them on a graph, and there you have curves. Wide, steep, inverted, etc...

excellent overview about yield curve from Yield curve - Wikipedia, the free encyclopedia

An inverted yield curve occurs when long-term yields fall below short-term yields. Under unusual circumstances, long-term investors will settle for lower yields now if they think the economy will slow or even decline in the future. An inverted curve has indicated a worsening economic situation in the future 5 out of 6 times since 1970. The New York Federal Reserve regards it as a valuable forecasting tool in predicting recessions two to six quarters ahead. In addition to potentially signaling an economic decline, inverted yield curves also imply that the market believes inflation will remain low. This is because, even if there is a recession, a low bond yield will still be offset by low inflation. However, technical factors, such as a flight to quality or global economic or currency situations, may cause an increase in demand for bonds on the long end of the yield curve, causing long-term rates to fall. This was seen in 1998 during the Long Term Capital Management failure when there was a slight inversion on part of the curve.

the rationale behind this is if you had a lot of cash (example, 100mm) and didn't have much faith in long term prospects of US economy, would you put it into a 30 year? or 10 year note? Maybe the 1 year or the 2 year makes more sense....

now we have an undertanding of the yield curve.

The way it applies to MBS Reits is these companies (which happen to be very complicated financial systems specializing in holding and trading instruments) simply use leverage to capitalize on the yield curve. This is the most simple way to view the companies. Now, the risk to the shareholders in the past has been the quality of the bonds and risk of default. In rare cases, the bond holders got screwed.

But when the bondholders gets screwed, that means all else has failed and the shit has really hit the fan.... creating zero value for shareholders.

Today, the US government has set precedent by entirely backing those higher yielding bonds issued by Fannie and Freddie and eliminating probably 99% of the risk. As a result, the longer instruments are minting money. The 3 months up to the 2 year notes are very low (big demand drives down the yield) So the SPREAD between the long and the short is HUGE. I don't know what they've been historically, but applying to basic calculation models that NLY, CMO, AGNC, ANH use shows these companies are making some serious coin.

This is their sweet spot. As the rates change for whatever reasons, that will immediately impact those same companies ability to make money

(for those who haven't fallen asleep yet- when you buy a bond with a guaranteed fixed coupon payment, the yield is determined by how much you pay for the bond. Example, a $1000 bond that pays $50 per year is a 5% yield. That same bond may be bought for $950 with a $50 pymt thus creating 5.3% yield)

Now, a mortgage backed security is nothing more than a pool of cash represented by mortgages that are be wholly guaranteed by Freddie or Fannie. During the height of this financial crisis, Fan/Fre were considered tabboo after they defaulted on their preferred stocks payments so to generate confidence the US gov't then guaranteed their interest payments on the bonds. (preferreds and bonds are 2 different classes, but pfd's have always enjoyed a prestige for safety, well no more)

the MBS Reits do not own real estate. they only own the paper that represents the liquidity in the RE markets.

sorry if this is so defragmented and spotty... I didn't thoroughly proofread and I am sure you'll have more questions. But on last note, the bond market IMO is a much stronger reflection of investor sentiments on the overall markets than all of equity markets. It's a much larger pool of cash, too. Keeping an eye on macro economic indicators i.e. unemployment, $ exchange, inflation/deflation, etc is crucial to determining bond market movements thus making it easier to forecast future MBS Reit share price movements.

Thanks for an excellent explanation. Helps me start to understand how companies like NLY can pay a 15% dividend from buying 5% mortgages.

Will take me a few more readings to really get it.

Any resources you can recommend for understanding the macro economics to be able to do well with this type of investing?

Just yesterday or today, Lloyd McAdams does a presentation for the company he chairs: ANH. it's a long presentation but really covers a lot of ground.... great primer. I didn't listen to all of it, but the snipets I got were informative, one thing I got was that ANH's leverage is about 5.5% ... others are into the low double digits as far as leverage is concerned. This is the link:

Wall Street Webcasting - Anworth Mortgage Asset Corporation


I also recommend reading Marylin Cohen's "The Bond Bible"

lastly, paying attention to Fed Beige book announcements like this mornings give a strong indication of how the Fed perceives the economy and gives insight how likely the Fed will raise rates.

It is essentially possible because of leverage. Let me give another simpler example to illustrate: You buy a house for $100,000 and put $20,000 down. The house is really worth $200,000 but you got a deal. You sell the house 1 year later for $180,000. So you used $20,000 (forget any paments, just assume no other costs for the purpose of the example) and sold for $80,000 more netting you a $60,000 profit. By using the debt (mortgage) as leverage, you were able to earn a 300% profit in 1 year.

This is a similar situation with companies like Annaly (NLY). They can borrow at 0% and loan at 5%. The they use debt leverage to increase returns. Annaly is a REIT so they must pay almost nearly all profits as dividends in order to avoid taxation, so you are also getting a dividend from pre-tax earnings.

a couple of more things to elaborate- the short bond rates is a reflection of the banking system. Overnight rate is low currently, signifying that banks are happily keeping fluid. When this rate spiked as it did last year during height of financial crisis, we saw extemely high short note rates because banks all but hoarded the cash in fear.

the long bond is a reflection of how the bond market sees the health of the overall economy. Currently, there's really no fear of systematic collapse, but there's still concern surrounding taxe rates, unemployment, deficits and state liquidity problems thus keeping money out of equities and keeping them in bond markets.

so that's why watching Fed sentiment is important. As soon as long rates decline or short rates spike, the MREITs start getting shot in the back of the building....

From Jeffrie's NLY report early November.... appears liquidity is keeping leverage down for all of the MREITs.....

>>>

Low Leverage Compared to Historical Standards –

– NLY expects to operate within a range of leverage between 8.0x and 12.0x on a debt-to-equity

basis. The company primarily accesses the repurchase (repo) agreement market to secure funding on a short-term
basis. As of 3Q09, NLY operated at 6.0x leverage. While leverage may only be managed to the extent that it is
available, Agency REITs do not typically exhaust all available sources of capital as margin calls and other cash

collateral requirements could fluctuate significantly on a daily bas<<<

this thread is getting a lot of views, so I thought it'd be appropriate to throw my thoughts out there. they're worth 2 cents so you'll get your money's worth.

unemployment numbers today are viewed very favorable by equities early in the day but methinks this blip is an abberation. Gov't unemployment calculations are tallied much much differently today then just a decade ago.

the double edge sword for us mortgage backed Reit holders is that they will start raising overnight rates as the economy begins to improve thus impeding MReits ability to make moolah on the spread

big auctions to tune of 135b going off this and next week. vast majority of them are short notes. Undoubtedly a reflection of how much money is flowing into the bond markets and this is just a theory but as institutions keep hoarding cash via treasuries, then there is less for them to lend out thus further drying up liquidity for loans. Who knows, it's just a thought....

looks like markets just changed sentiments and S&P is down now.

If unemployment continues improvement in the next 60 days the way it did in today's announcement, then look out from the Fed with trigger fingers to start jacking up rates to help strengthen the dollar in hopes of paying off the debt faster... probably not until after 1q2010, but nontheless the writing will be on the wall. And this is important to anticipate to avoid a slaughter in the MBS market

now would be a great time to tighten up your trailing losses on your MBS REIT's like NLY. I have tightened my stops already. As randall stated, once the news comes out that the fed is raising rates, this will be a big hit to this sector. Because of their leverage, it will severely hit their bottom line and the big investors know this. This sector is on eggshells right now and is being watched closely. As long as the fed keeps rates low, it makes buckets of cash. Once the spread closes, not so much.

As a side thought, the day (or day after) the fed raises rates, as long is it is a small raise like 25-50 points, these MBS REITs will tank. This may be a good buying opportunity for the market leaders here. Although the spread will be smaller, the fickle investment community will likely punish them for the fed news and the dividend yields will probably be quite good. At the minimum, its worth putting on your watch list.

GW- look at rate charts from 2004. Fed jacked up their rates every meeting and drove it to 5.25% if memory serves correctly.

at the end of the day, the news of the rate increases impacted the stock values a lot more than the actual rates did during that tightening period and dividends were still being declared.....

today's economic climate is MUCH different than it was a few years back:

The economy was really on fire and productivity was at unbelievable levles, which contrasts our scenario today.

-The tax burdens will be here to stay, back in 2004 the big talk was how many taxes could be cut or eliminated.

-Unemployment was 5% using more conservative estimates vs. today's 10%

-Banks/lenders had a lot of liquidity vs. today's very hoardish mentality.

so, the Fed would be practically asking for a coup d' tat if they jacked up rates at the pace they did in 2004. Methinks they have certain levels of deflation, budget amounts, foreclosures, tax income and unemployment among others that triggers Bernanke to raise rates.... the other side of the argument is that Bernanke is content with stabilzation and a prolonged period of the "new normal" is justified to jack up rates even if unemployment stays at 10%....

but my crystal ball says we're a long ways economically from that point. still very, very long NLY, AGNC, CMO, ANH. I also have a small wad CIM which I didn't mention before but it's not agency debt.... (wish I had more - that's been a mighty fine performer.) do your dd.

Very interesting to look at the manipulation of the fed funds rate. It has an direct correlation to the conumer savings rate.





You can clearly see how the decrease in the interest rates caused a decrease in consumer saving, which of course caused the increase in a debt fueled spending spree in housing and all consumables.

This couldn't paint a more clear picture of how government intervention was the primary cause of the housing bubble and subsequent economic crisis. And now our policy makers think more regulation is the answer to the problem.

savings rate down all the while the consumer debt is decreasing... you can bet your bottom dollar the low rate is deflating, no pun intended.

btw, the 28 day UST went off today at ZERO percent! That's right. No rate of return when you buy US T Bills these days
http://www.treasurydirect.gov/instit...20091208_1.pdf

Can you explain to me who would be buying this debt, and even more puzzling to me, is WHY?

I love this thread btw

If you have $50K to save, you put it in a savings or money market account. But if you have $50B, your local Bank of America is not a good choice because you are only protected by FDIC up to $250K. Obviously an individual doesn't have $50B, but governments and large companies around the world do have billions in cash and need to put it somewhere in order to keep it safe and 'hopefully' get some kind of return. Right now you or I would be crazy to buy treasury notes, but countries like India and China which have budget surpluses must do something with that money so they park it in US treasuries. That is shifting toward other assets though like gold, silver, and other currencies.