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PERSISTENCE, PERSISTENCE, PERSISTENCE

The following research comes to us courtesy of Annaly Capital Management:

It is very hard to presume any sense of accuracy when answering the question, “What will market conditions be in the future?” There is the rub, because the future is what matters most to an investor. Investors, however, know the past and present cold. Thus, it is somewhat more comforting to ask the same question in this way: “How long will current conditions persist?”

The Federal Reserve understands this problem, and nodded toward it yet again in their January 27 FOMC statement by maintaining their commitment to keep the federal funds “exceptionally low…for an extended period.” Presumably, this means the current rate at 0% to 0.25%. That still leaves some uncertainty on the table, but it provides a semblance of forecastable conditions for one point on the government yield curve. What about the rest of the government curve? And the curve for other asset classes? There is no such guidance from the Fed, because the fed funds rate is all it controls (please, no angry blog comments about the market manipulation resulting from the Fed’s active involvement in the financing markets and open market purchase operations).

For answers to those unanswerable questions, we have to fall back on the past and present. The two stacked graphs below try to show the relative yield at two points on the government yield curve (Fed funds and the 10 year Treasury) and the mortgage finance curve (the current coupon mortgage-backed security and 3-month LIBOR). The vertical red lines indicate the beginning of a Fed easing cycle. After the Fed started easing in June 1989, the government curve steepened to more than 300 basis points and stayed that way through 1995, six years later. After the January 2001 easing campaign got underway, the government curve stayed steep for about five years. The mortgage finance curve is similar (although it never inverted). Today, we are a little over two years into the easing campaign. If history is a guide-and there is, of course, no guarantee that it will be-these curves will likely remain steep for some time.

Source: Annaly

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