MBS CLOSE: Continuing Discussion Of Range-Finding
Stocks and bonds rallied hand in hand today after a better than expected 30yr bond auction. Perhaps it would be more appropriate to say a "not worse than expected" 30 yr bond auction as the numbers didn't depart massively from recent trends. But whether you chalk it up to the absence of a negative surprise or the presence of good demand for long term debt, the result speaks for itself as the long bond rallied over 2 points and catalyzed a flattening of the yield curve that left 2's10's 10bps better at 245bps. That's a substantial one day move...
You might be wondering what's going on when stocks can rally to their best levels in over 3 months at the same time bonds are rallying. In a word: uncertainty. It's diminishing... We've talked in the past about the premium that our borrowers have paid and continue to pay due to uncertainty. In response to one day of particularly harsh lamentations of MBS price recalcitrance, I noted that MBS in and of themselves would NOT have to improve beyond current levels for rates to come down to "greener grass" levels that illicit so much longing among originators.
It's all well and good to discuss those sorts of things from a theoretical standpoint. And whether you understood my argument or dismissed it as purely theoretical, it didn't much matter. The only truth that mattered is that rates WERE NOT where we wanted them to be and simply understanding why they COULD be in the future didn't do anything to accelerate the process.
Yes, unfortunately, like so much else in the market, it's one of those things about which we'd just have to "wait and see." But today is one of those days where the writing is on the wall. Better than expected long term bond auction and STOCKS rally? Better than expected jobless claims and BONDS rally? Wait... What? It's all a matter of shoes in the sky.
With each passing release of jobs-related data that's merely CLOSE to expectations and each passing tsy auction that's merely decent, uncertainty about the MAGNITUDE, RAPIDITY, and STABILITY of any iteration of the concept of RECOVERY is gradually peeled away to reveal an ever-sharpening picture of exactly what the hell is happening and about to happen in the economy.
It's a second-nature concept for some and has been discussed in recent months in our commentary, but it bears repeating: UNCERTAINTY INCREASES COSTS. Whether you want to approach this with the utmost simplicity or with complex financial analysis, the core concept is the same. THE MORE DIVERSE THE EVENTUALITIES FOR WHICH INVESTORS MUST ACCOUNT, THE MORE EXPENSIVE THE OVERALL INVESTMENT. Don't even get me started on analogies for that one, but the first one that jumped to mind is horse racing. If each horse represented a different potential outcome for the current economic uncertainty, we'd have to spend a lot more money to break even at the end of the day than if the winning horse was already known.
Although the situation is thankfully not so dire as to try to choose between more than a handful of outcomes, the principle of uncertainty increasing cost is the same. From a more tightly focused market-based perspective, if an investor is uncertain about the shape of the recovery, the costs to HEDGE against loss are higher than they otherwise would be.
And so it is that we see stocks and bonds advancing in concert. Of course the battle is far from over, but days like today, where MBS can endure the full force of the settlement related price drop and STILL emerge in the green, AND where bonds are up, AND where stocks are up, are a welcome change from settlement days past where the drop has been an insult (albeit completely known ahead of time and inconsequential to everything but our emotions) to injury done by price losses in the immediately preceding days and hours. In that recent time frame, the aforementioned phenomenon is due in large part to MBS having a bit of a pendulum effect coming off the quasi-euphoric price movements culminating in "supportive week."
But no rebound this time... At least not yet. In fact, you'll be able to see in the day over day chart that the this rally cycle is longer AND more stable than previous cycles. Uncertainty leaving the market definitely helps. Oh, and lets not forget the summertime participation factor finally being behind us either. Whatever the case, the net effect is a 10 year not at the same level now as it was when the S&P was OVER 100 POINTS LOWER! That's a decided move from the sidelines... Although MBS were left FAR behind tsy's today in terms of the magnitude of gains (read: widening spread), at the very least, the rally has provided an environment in which MBS could maintain a stable trading range.
In fact, it's all about the range today in MBS. We discussed "range-finding" earlier on a more micro level, but let's see how that played out against the longer term perspective. One of the mitigating factors alluded to in the Lunch commentary was the impending price drop associated with settlement and that we could not help but consider it in any even remotely meaningful discussion about ranges. So the range-finding task set to MBS today was doubley difficult. Not only would we have to fall in line with the broader market's consensus about events, but we'd also have to satisfy analysis in terms of both pre and post settlement price levels. Sure, we could always throw out a little bit of post-settlement deviation from trend if prices departed but came back fairly quickly, but truth is stranger than fiction:
At first glance, MBS were trending along "higher lows" quite nicely all day. At the exact level where that trend was broken, so too did we close out the day. This then would serve as the starting point for the first part of the equation yielding the new price after settlement, or what has been known for a while know as OCTOBER CLASS A MBS. I saw the drop start out at that exact 101-04 level and observed the result. First I was pleased that we actually get to say we ended 2 ticks up on a front month coupon ON THE DAY OF THE DROP!
To be frank, I had expected not to put too much stock into trend for the next few days until I saw this. It seemed "too technical" of an occurrence not to dig a little deeper. It didn't take long as the starting point for that investigation provided the answer. We had a chart up yesterday about several levels of aggression among competing uptrends. I wasn't optimistic about holding those from a "front month price perspective." In other words, although I wasn't expecting negativity for any particular reason in the bond market, I knew it would be hard for our ongoing chart of MBS prices to maintain the trends considering that we'd soon be subtracting 12 ticks from the price level. But check out where we ended up on the day...
I purposely shifted the starting point of the line a bit higher so that you could still make out the MBS price curve. But essentially, we're still riding one of the more aggressive trends of higher lows. Not only that, but the intraday trend we were riding today turned out to be none other than the incredibly long internal trendline that we discussed yesterday as probably the most significant trend in MBS all summer. So so follow the quintessential middle path of improvement all day and then to adjust exactly where we would have needed to adjust in order to maintain a vote for the continuance of that uptrend seemed to me something that bordered on providence. I'm not really sure how to convey it, but essentially, the MBS market did no more and no less than exactly what it needed to do today to stay on course.
The reason this is a good thing as opposed to MBS rallying in step with Tsy's is history's lesson that overdone rallies are not good for short to medium term stability (or even palatability) of our rate sheets. The slower and steadier the rally in MBS can be, the fewer the reprices, the smaller the primary/secondary spread, and the better rates overall we can offer to our clients.
As far as technical suggestions of stability in rates, it was very important for us to get the bounce we did today in tsy's. And although that benefit has more to do with avoiding bad scenarios than it does with moving toward good ones, at least now we live to "wait and see" another day.