Tuesday 7/15/08 ... Action-Packed Day, Positive Price, Gappy Spread

Its our favorite kind of day!  When the dollar price rises at the same time as spreads blowing out to nearly all-time wides, in my mind, it only sets the stage for strength in the future.  Two weeks ago, it had looked like spreads were not going to get any wider, but things have happened that have caused an uncommon amount of risk aversion among "flight to quality" buyers.  Despite the large yield premium offered by MBS, considering the incredibly weak economy and a high degree of uncertainty in the financial sector, traders have been more apt to buy risk-free treasuries.  If there was ever a time in history for spreads to be wide, it would be now.  But the "now" should pass.  Consider that mortgages are the underlying asset that back MBS, and that spreads widen when the return of those mortgages is in question due to default or prepayment concerns.  We know that, as underwriting standards have risen, and prices have lowered, that the people that are actually getting loans today are much better credit risks than those in the loans that contributed to the meltdown.

I'm almost confident enough to say that we are entering the period that historically leads to the best bond prices of the year by wintertime.  Call it Serotonin-based risk aversion or a failing economy, whatever the case, historically, rates peak in the summer time and improve into winter.  Either we just saw that peak, or it will come before 8/30.  Remember, this assumption is based on an 80% generality.  It's "probable," but not "guaranteed."  Still, if the stage was ever set for improving rates, it is set now:

1. Dow Under 11k, and analysts point to more losses

2. Core inflation tame, oil demand waning daily.

3. Bernanke unlikely to raise rates this year.

4. Spreads near all time high (nowhere to come but down?)

5. Treasuries doing fairly well, Value bid to MBS when risks wane?

6. When risks wane, Global inflation should create high demand for spread product.

 
Really, with the exception of inflation, the outlook is extremely good.

We're out of the woods today as far as MAJOR unexpected price changes go ONLY as far as scheduled data is concerned.  Of course, headline risk can throw us a curveball.  Because of that, it will be a flotational day today, and because of the sentiments in the opening paragraphs, indeed a very flotational period in general.  If you have more than two weeks to make decisions, it may be hard to go wrong in the near future.  This is not firmly decided yet, but it is more likely than not at this point.  As such, float stances may be a little more aggressive in the days to follow.  I'll qualify them by saying, this stance assumes you could get the price back by waiting a few weeks.  If you don't have a few weeks to wait, adjust accordingly.

Floating last night at least, although a bit of an aggressive call considering the circumstances, was a good one.  If we can but get some pacifying headlines about FNM/FRE, or some good buzz from the Bernanke Q & A going on currently, we'll be in great shape.  We've already tightened a bit to treasuries during the time Uncle Ben's been answering questions.

If you do float, you do not have permission to tune out!  The trend is good, but things can always change.  As the Dow has rallied in the last few minutes, treasuries have sold down ten ticks or so, which has compacted MBS gains by about 3 ticks (hence the tightening).  If treasuries continue to drop/rise in yield, and stocks continue their march towards even on the day, it could push MBS further down, so stay tuned for another update shortly.