Wednesday 7/2/08 ... What Was That "Leash" Metaphor About?

 Let's talk about the master and the dog.  The master has a leash around the dog's neck.  This leash allows the dog to stray a certain distance from its master's side until it will tighten, forcing the dog, at the very least, to move in the same direction as its master.  It may stay all the way back at the maximum distance behind the master, or it may even dash ahead of the master until the leash begins to tighten again.  The final caveat for this leash is that, although its range is more or less fixed, if the dog exerts tremendous effort, there is some slight elasticity at the leashes outer limits.  So even though its only a 10 foot leash, for example, if someone left a very tasty looking plate of bacon on the sidewalk 15 feet behind the master, the dog may pull so hard that the leash could stretch to 11 ft. 

The master is the Fixed Income Market of which Treasuries are the benchmark, and MBS is the dog.  The leash represents the difference between the yields between the two.  An MBS coupon will usually pay somewhere in the neighborhood of 200bps (2%) higher yield than a comparable maturity treasury.  This is why we are focused on the 5 year treasury currently as the 6.0 MBS is performing at roughly a 5 year payoff (prepayment) speed.  In recent days the dog has been lagging farther and farther behind the master.  As of today, the leash is more or less at it's nominal maximum 9-10 feet.  As a result, if the master slows down, stops, or moves backwards, the dog could stay right where it is.  This would equate to a case where MBS price stays dead even despite treasury prices going down.  Conversely, if treasuries improve, MBS should also improve.  If the leash was only out 5 feet, it would be plenty of room for treasuries to improve and MBS to worsen.

The moral of the story is that spreads have blown out so wide in recent sessions that they are unlikely to get much wider.  Indeed just minutes ago, treasuries were 5 ticks improved on the day and MBS were 2 ticks worse, and when treasuries improved 2 ticks, so did MBS.  Of course we put the caveat of a slight elasticity in as a disclaimer that certain events can stretch the leash beyond the 10 feet, but these occurrences would be an exception to the rule.

Spread in and of itself doesn't give us any direction as to where rates will go.  We are only concerned with raw dollar price, which is harder to predict.  All markets have had a flat reaction to today's data.  It's uncertain if yesterday's weakness in MBS is the end of the pain for this week.  Traders are likely staking a great deal on tomorrows NFP (as they always do).  Expectations are pretty low, but if ADP does prove to be any sort of an indication, we could actually trump expectations tomorrow with a bigger decline in NFP than expected.  This would likely be good for Fixed Income and thus, because of the stretched out leash, also good for MBS.

All markets are flat right now, so as opposed to having a clear indication of directionality, we must wait for headlines and stock movement.  This means you'll have to be ready to lock at a moment's notice, thus the "extreme" vigilance ranking.  Delivering moderate comfort is the maxed out leash AKA spread between MBS and UST's is at the top end of its range.  So the 5 year note will serve us some sort of purpose today, because we know if the leash is maxed, MBS should not be declining if UST's are holding steady or improving.  However, if UST's decline, make sure you go check on your plate of bacon!  A ravenous dog may soon be approaching.  In other words, check back here to see if MBS is maintaining that tension on the leash as treasuries decline.  If this is the case, reprices for the worse may follow.