MBS CLOSE: Massive Price Drop (Exactly As Expected)

Narrowing trends continued through the close, well at least in tsys.  MBS did have a similar trend up until the close, at which point the January Class A (Fannie & Freddie 30yr's) went away, leaving us with February coupons as the new "front month" aka "on the run."  So truly, that 10-11 tick drop is exactly as expected and though it may look "unfriendly" in the following chart, it does not affect pricing as far as rate sheets are concerned.

In fact, 4.5's only lost 2 ticks AFTER factoring in the effects of the drop, so marking MBS at 3pm with the rest of the bond market shows we actually made about 6 ticks of progress today.  But the extent to which bonds are up or down today doesn't matter much given the context.  Not only was there virtually nothing to drive bond directionality today (just over HALF of recent average volume), we have auctions coming up tomorrow, starting with $40,000,000,000 in 3yr notes.

At 288 bps, the all time steepest 2's v 10's curve got little attention today.  Indeed it's a unique time for the yield curve as the long end is generally pummeled with recovery expectations and supply among other things and the short end is continually buoyed by their bff, the Fed.  It's a double whammy for the curve as the economic bears draw on the Fed's short term policy as they buy the short end, and others with concern over issuance/inflation, sell the long end.  The curve is on the wrong side of the "heads I win, tails you lose" game.

To whatever extent that the upcoming data doesn't add fuel to those fires and that auctions are well-received, more than a few short positions can be covered in the long end.  It could even go as far as "relief rally" status, but pausing for earnest reflection, if not outright reversal at this years tsy yield you love to hate at 3.75%.  Unfriendly data and lukewarm or even poorly received auctions could just add fuel to the fire.  But unless those indicators and results are fairly ugly, it's hard to imagine current levels as attractive entry points for further steepeners or shorts.

PLAIN AND SIMPLE: Since December, treasury yields are much higher and the gap between the 2yr and 10yr yield is as wide as it has ever been.  Economic optimism, fear of inflation, and concern over the high level of debt being issued (supply) can drive that gap wider, and especially long term rates higher.  The short term has remained strong by comparison due to the waning belief that a Fed hike is imminent. 

But current levels are high enough and the yield curve (gap between short term and long term rates) steep enough that even if negative trends for rates are to continue that neutral data would likely give way to short covering (essentially the opposite of "profit-taking" after bonds improve, this is simply the profit-taking on a short position), and flattening (betting on a short term correction of the all time steep yield curve).

Without context, short-covering and flatteners might make too much sense to ignore, but given the fact that bonds failed to capitalize on a few opportunities last week to capitalize on data, and that volume remains low, there are no sure bets going into the auctions, not to mention the perennial law that just when you think you know what the market should/will do next, it does the opposite.

So we'll look to the auction results and the data to gradually give more clues as to how things will shake out.  As previously mentioned, that begins tomorrow, but before the 3yr note auction at 1pm, we get the Trade Balance at 830AM Eastern as the sole data point of significance in the AM.    The latter parts of the week get more exciting in the mornings.