QEII Cleansing Process Continues in Bond Market

Treasuries got smoked again, with another huge uptick in intermediate-maturity yields. The 10-year closed down almost 1 ½ points from Friday’s close, pushing its yield back up to 2.96%. The 5-year also sold off hard, but its yield rose only 16 basis points. The 2-10 spread widened out to +242 basis points, and hasn’t been this wide since early August. The 10-30 spread narrowed, and at +145 is approaching where it was in October before the QE2 frenzy took it out to +160.

There were a number of catalysts for the selloff, including better-than-expected reports on Manufacturing and Retail Sales (although the Fed’s Empire State manufacturing index posted a print so weak (-11) that one has to wonder if someone forgot to take the survey and just mailed in the results. There was also some acceleration of the buy-the-rumor/sell-the-news trade for QE2, as well as speculation that the program might be smaller than originally conceived, given the public spanking from domestic and foreign leaders. (Alan Blinder, the former Fed Vice Chairman, gives a spirited defense of Bernanke in Monday’s Wall Street Journal, however.)

Mortgages didn’t have a horrible session, at least if run to the day’s starting hedge ratios. Fannie 4s probably underperformed by 3-4 ticks, although hedge ratios were almost certainly lengthening by late in the day. Fannie 3.5s sold off by about 1 8/32s, which keeps them about even to opening hedge ratios. With a significant pop in implied volatilities, option-adjusted spreads were probably even or tighter versus lower coupons. Higher coupons had another strong session; Fannie 5.5s outperformed the 5-year by almost a quarter-point.