U.S. Rates Rally as Bailout Talks Shift Back to Spain and Portugal

The risk trade is off again this morning as the dollar gains value and U.S. TSYs catch a bid while stock futures deflate. That might be a bit dramatic though, equity retracements haven't been sizable or broken range and most commodities are trading in the green with the exception of Gold and Natural Gas. Plus short covering is a source of strength in the TSY market this AM so we can't get too excited yet. At least we're not retesting 3.00% again  (that 124-00 options strike trade I discussed last week expired on Friday btw).

So the market continues to send us mixed messages. Is the Euro debt contagion crisis helping or hurting our cause?

Since the Irish lost their luck we have witnessed several sprints back to the safety of Mommy and Daddy (U.S. = parents to rest of world) , but the majority of those flights to safety have been tied to general uncertainties surrounding EU debt valuations and whether or not further bailouts will be necessary to boost investor confidence and bolster international banking systems.  The "confusion" was clear last night via the initial reaction to the release of Ireland's bailout agreement. Longer dated TSYs sold off and Euro debt spreads tightened as Asian markets opened , implying our benchmark guidance givers are vulnerable to a brighter outlook abroad, specifically in Spain and Portugal. Since then we've witnessed a complete 180.  Debt spreads have widened out, equities have lost their bid, and U.S. Treasuries are rallying.

It's important to remember these issue take time to work out and we still don't know if sustainability plans will even work. Greece might need more help down the road and debt restructuring has yet to be ruled out. In short, the market remains tactical and is riding momentum and technical biases toward profitability.

Here is my CDS screen.  The market is now focused on forcing Portugal and Spain from their fox holes, this is obvious via record wide CDS spreads vs. the U.S. benchmark. Germany is really regretting their involvement in the EU.

Looking more closely at our own interest rate situation, a general lack of liquidity and mixed perspectives on the above discussed contagion concerns contributed to quite a bit of chopatility in the holiday shortened session that was last week. 10s opened the week in the high 2.80s, rallied as far as 2.73%, and ended the week not far from where we started in the high 2.80s. FNCL 4.0s opened the week at 101-16, fell as low as 101 the rock and rose as far as 102 the dollar before going into  the weekend at 101-11. I won't comment on loan pricing because lock desks were on autopilot and rebate reductions didn't necessarily reflect competition in the primary mortgage market, but the majority of positive progress unraveled on Wednesday morning following a better than expected read on Jobless Claims, indicating the release of the Employment Situation Report this Friday carries the potential to dictate rate directionality heading into the New Year.

As the dust settled on Friday and we put together the pieces, we found that the Bulls vs. Bears QEII cleansing process had taken another step in the right direction for originators. Trader positions have balanced out (longs vs.shorts) and a clear line of support has been drawn in the sand at 3.00% in 10s and 101-00 in FNCL 4.0s. Unfortunately while positive progress has been noted, the technical environment still favors the bears, so any interest rate rally attempts will likely be met with scattered barrages of selling pressure and profit taking as bullish TSY investors cautiously add new longs against a herd of fast$ short sellers.  That herd has however seen its numbers dwindle but like I said above, positions are much more balanced than they were in mid-October so the market is really ready to head in either direction (hence the warning re: influential Employment Situation Report).

Personally, I am expecting to see rates rally leading up to the release of the Employment Situation Report on Friday. There are no TSY coupon auctions and the Fed will be busy with six TSY buybacks. Plus the calendar roll brings month-end index extension buying as well. Both of these events will draw $$$ into bonds. On top of that tensions remain high in Europe, China, and Korea. This leaves the bond market open to a continued flight to safety bid. If all goes well, we will be faced with a difficult decision on Thursday night.  To float through the Employment Situation report, which folks expect to be strong at +140k jobs (relative to how crappy the labor market is for folks who want full time positions), or take profits on modest gains and move on with life. The waiting game continues but it seems like we're getting closer to a final verdict. We'll either be stuck near current rate levels into year end or 3.5 MBS will start trading and 4.25% loan pricing will make a resurgence.

Recently optimistic econ reports are my main cause for concern.  The week ahead offers plenty of data points for us to judge the market's sensitivity to new data. Again, we do anticipate a long slow recovery but the market's investment horizon is still short term and biases are largely tactical. This means momentum will be one of the market's main motivation for movements. If econ data continues to be better than anticipated, it could spell trouble for 3.00% yield support in the 10yr and 101-00 price support in FNCL 4.0s.  Weigh that against ongoing EU contagion concerns, conflicts in Korea, political jawboning in the U.S., six Fed open market operations, and month-end index extensions. Basically if bond investors really are that confident the economy is improving at a faster rate than anticipated, there are several bullish TSY influences they must overcome to illustrate their point of view.

MARKET INDICATIONS...

FNCL 4.0s are just below session highs, currently +8/32 at 101-15. The yield curve is 4bps flatter at 232bps wide but off its firmest levels of the day (230bps). The 10yr note continues to lead a cautious TSY rally. 10s are +9/32 at 98-05 yielding 2.839%. 10s touched 2.813% early in the day. Between the December and March contracts, TSY trading volume is healthy for 11am.  I'd say a good portion of those flows have been short covering.

I haven't updated my loan pricing model yet. That is next on my to do list....

FYI: the CFTC will release the COT report today.