The economy is booming. Second-quarter earnings were absolutely spectacular, up over 80% on average, with the largest percentage of companies exceeding expectations in history. Yet, the 10-year Treasury rate has been falling. How can this be?
The 10-year Treasury is a benchmark for long-term interest rates. Typically, longer rates rise when the economy booms, as borrowing demand increases and investors gravitate away from low-risk assets toward stocks in a bull market. But the opposite has been happening.
The benchmark rate has fallen from a high of 1.75% in March to below 1.2% in early August (currently 1.35%) while the economy was unleashed into full recovery. There are several reasons why rates fell.
For one, the market tends to anticipate. It looks beyond the current pandemic recovery to a more normalized environment in the near future. Economic growth may be stratospheric now, but it will decelerate in the quarters ahead. There’s also the Delta variant, which will curtail economic growth at least to some degree. And then there’s the Fed.
Central bank meddling skews normal market behavior. The Fed has been buying $120 billion worth of government and agency bonds every single month since the pandemic first started. The purchases have the effect of holding down longer-term interest rates.
But the Fed is likely to start tapering those bond purchases before the end of the year. The reduction and end of those purchases will eliminate a strong force holding rates down. Plus, a “normalized” economy should still have higher rates than the current 1.35%. Before the pandemic the 10-year Treasury averaged between 2% and 3%, in both the Obama and Trump administrations.
In short, it is highly likely that longer-term interest rates have fallen too low and are likely to rise in the quarters ahead. Meanwhile, certain stocks that should otherwise be thriving in this economy have been held back by the falling rates. These companies profit from a steeper yield curve — the difference between long- and short-term interest rates.
The current situation has created a buying opportunity in these stocks and should again thrive when the situation likely reverses in the months ahead. Here are two good ones.
AGNC Investment Corp. (AGNC)
AGNC is a mortgage real estate investment trust (mREIT) that invests predominantly in U.S. government-backed residential mortgages. It pays a high dividend yield and makes dividend payments on a monthly basis.
While typical REITs own actual physical real estate properties, charge rent, and pass that income onto shareholders, mortgage REITs are a different animal. They buy mortgages and generate income from monthly mortgage payments. A mortgage REIT borrows money at low short-term rates and uses that money to buy mortgages that pay higher long-term interest rates, making a profit on the difference, or the net interest spread.
AGNC invests almost entirely in mortgages backed by Fannie Mae and Freddie Mac, so there is virtually zero credit risk. However, there is certainly interest rate risk. It’s all about the spread. If the difference between the short-term rates at which it borrows money and the mortgage interest paid increases, so do profits. When the spread decreases profits fall.
AGNC has been thriving in the market recovery as the economy recovered and interest rates rose. The stock rose from under 10 per share in the pandemic bear market to almost 19 by the end of May this year. Since then, AGNC has pulled back to the current 16.50 per share as the flattening yield curve has weighed on profits.
But despite the lower rates, business is solid in the booming economy as mortgage demand is high. The REIT is earning more than enough to at least maintain the current dividend. So, you’re getting a safe 8.8% yield on a stock that is likely to appreciate if rates trend higher.
U.S. Bancorp (USB)
U.S. Bancorp (USB) is the fifth-largest bank in the United States and the country’s largest regional bank with over 3,000 bank branches in 25 states in the western and northern U.S. The Minneapolis bank was founded in 1863 and now has more than 70,000 employees and $543 billion in assets.
The bank offers a wide range of services. There are four main divisions including consumer and business real estate banking, corporate and commercial banking, wealth management services and payment services. That probably sounds more complicated than it is.
Like most regional banks, revenues are generated primarily from net interest income (NII), which is the rate spread between the cost of money and the loan interest charged to customers. Half of the loan volume is to businesses with the rest primarily from residential mortgages and personal loans. The rest of the revenue is derived from banking fees.
Banks took it on the chin in the pandemic as loan activity dried up during the lockdowns and interest rates crashed. They didn’t participate in the recovery until last fall when the vaccines came within sight. From September to May USB stock soared 77% as business recovered with the economy.
Last quarter’s earnings were stellar as loan volume and fee business soared. But net interest income tumbled amidst the falling rates. The stock has floundered since early May because of the flattening yield curve. Thus, despite the booming economy, USB is still priced below where it was before the pandemic.
The huge recovery in USB was interrupted by falling longer-term interest rates. That recovery should be reignited if rates trend higher.
Do you own any dividend stocks impacted heavily by the yield curve? If so, tell us about them.