MBS CLOSE: Auction Punishes Long End, MBS Fare Better

By: Matthew Graham •

After the dust settled today, the 30yr bond was down over a point today whereas 4.5 MBS had only lost 3 ticks...  There was plenty of sturm and drang along the way, especially for those of you that keep tabs on bond prices in addition to MBS, but taking that familiar cruise up to the 50,000 foot view should provide some perspective why things happened the way they did today and what it might mean going forward...

Thursday 10/8 At A Glance

  • stronger jobless claims send yields higher in AM
  • bond bulls still prevailed pre 30yr auction
  • Auction disappoints, duration shedding extravaganza
  • MBS put the big tightener to the curve (treasuries yields rise a lot, MBS only a little)
  • Fed buying stays strong
  • prepare for "plain and simple" on today's auction dynamics

What gives?  Yesterday's auction seemed like it should have created even more demand along the long end of the yield curve than it did.  Then today's auction's HIGH yield stopped at 4.01, yet by the end of the day we're looking at massive losses on the long end of the curve and the 30yr yield backed up to 4.09!  The pleasant caveat to all this is the tightening spread between MBS and Tsy yields which helped MBS avoid almost all of the losses experienced by treasuries today.  For the sake of comparison, 10yr yields backed up from 3.16 at their lows today to 3.25 at the close, or 9 bps.  Mortgages by comparison only backed up 2bps during the same time frame. 

Whether the forces at play in the bond markets today were exceedingly complex, I'm not sure, but certainly, our normal explorations of the MBS market seldom include the amount of detail necessary to give an accurate account of today's events.  Still...  We'll try...  Just be aware that tonight's commentary will likely be followed up as we connect our thoughts on the day to tomorrow's eventualities.  So rather then entitle what follows "Plain and Simple," just bear with us as we break things down a bit more than normal...

Background

It's hard not to notice the regularity with which we make mention of the bond rally that has occurred, in general, from August until now.  The following chart demonstrates this, as well as the concomitant salubrious effects on MBS.

This trend might continue in the long run and it might not, but the macro considerations that speak to that possibility merely serve as the starting point for the shorter term and more complex trade flow considerations that drove today's sell off.  Even if the rally does continue, what has been happening to treasury yields more recently?  What happens when we zoom in on the treasury portion of the above chart?  Let's add some volume as well...

Long story short, TREASURY YIELDS HAD MOVED LOWER DIRECTIONALLY ENOUGH AND WERE APPROACHING YIELDS THAT WERE LOW ENOUGH THAT THEY WERE INCREASINGLY SUSCEPTIBLE TO AN EVENT-PRECIPITATED SELL-OFF.  That's just the background...  Let's construct the "event."

  1. Yields began their dance with data today AHEAD of Jobless Claims. 
  2. After Claims, yields continued to back up, but only marginally.  At that point, the 10yr encountered significant resistance at 3.21 which we discussed in the OPEN and MORNING commentaries. 
  3. Up until this point, as has been the case with most every announcement/auction cycle in recent memory, MARKETS HAVE "SET-UP" FOR SUPPLY WITH CONCESSIONARY SELLING.  In other words, yields have moved higher AHEAD of auctions only to ride the waves of "relief buying" upon palatable auction results.  Plan for the worst, hope for the best, no?
  4. After so many instances of this in recent months and after yesterday's better than expected 10yr auction, there was more "relief buying" to come.  Those who had previously SHORTED treasuries began to UNWIND THOSE SHORTS (short covering in this context = buying treasuries) this AM.  Whether you call it a "short-covering rally," or the "unwinding of concessionary supply set-up," flatteners (trades that favor a reduction in long duration yields versus short duration yields) were added all across the curve and yields dropped this AM into the danger zone of bond price richness.
  5. During this time, the rumor mill also suggested that certain foreign accounts would be buying elsewhere in the bond world which resulted in additional hedge lifting from the dealer community
  6. Enough traders saw yields as low enough after the lunch hour (ending at 1230) that they were able to push yields up briefly with a bit more concessionary selling squeezed in right before the auction, but it was no match for what was about to happen.
  7. The Auction stopped out with a 3bps tail meaning that the the 30yr had been trading at 3.97 and met a high yield at auction of 4.01.  But worse than that was the surprisingly low participation from direct and indirect bidders.  Primary dealers are required to tender offers at bond auctions.  They plan on a certain amount of other direct and indirect bidders to soak up some of this supply.  In short, the dealers don't want TOO much, especially if they feel the yield is a bit low.
  8. The participation did two things: it showed that yes, yields are too low to garner much excitement among other traders AND MORE IMPORTANTLY, IT STUCK PRIMARY DEALERS WITH MORE 30YR BONDS THAN THEY WANTED, ESPECIALLY CONSIDERING THEY'D JUST BEEN SENT A BIG MESSAGE ABOUT THE RICHNESS OF THOSE YIELDS!  It was time to sell...
  9. the % of the auction "taken at high yield" is informative here.  Treasury auctions are Dutch, meaning that the issuance begins getting assigned to bids starting with the lowest offered yields first and "stopping out" whenever there's nothing left to assign.  Dealers who are required to bid would naturally like to be holding a security that is paying them a HIGHER yield.  So when a low percentage of the auction was taken at the high yield it can means that dealers did not necessarily get the yields they were expecting.  They'd be expecting slightly higher yields based on the other direct and indirect bids THAT CAME IN MUCH SHORTER SUPPLY THAN PREVIOUS AUCTIONS SUGGESTED.  Once again...  It was time to sell...

 

There's much much more to discuss, but owing to the lateness of this post in addition to certain junior MBS junkies that need to be picked up from school, we'll break this into two parts and discuss the dynamics the fed and informed the sell off throughout the rest of the day TOMORROW.

USE THE COMMENTS SECTION TO ASK FOR CLARIFICATION NOW (on the chance that we can read your questions before we start up the second half of the discussion tomorrow.  We promise it will end up being informative to the broader near term future as well!)

Good Night.

MBS, Tsy, and LIBOR Quotes