Rates Chop Around Well-Defined Range. Liquidity Still Lacking. Flows Still Thin

With Japan, China, and the U.K. out on holiday it wasn't a big surprise to see domestic bond traders looking for a retest of last Wednesday's low volume Treasury rally. Especially after 10s crossed through 3.30% on Friday afternoon, leaving little room to rally without a clear shift in investing outlooks. This behavior once again highlights the exaggerated influence of thin trading conditions and a lack of liquidity.

We do however look for the bond market to paint a clearer picture of its strategic bias in the day's ahead as attendance picks up and sidelined money goes back to work.  The release of the December Employment Situation Report will likely play the biggest role in directional motivations but we've also got FOMC Minutes tomorrow and five Fed buybacks in between..not to mention a sleeper of an ADP Report that could lead to bargain hunter frontrunning if it confirms the unanticipated weakness we witnessed in the November Employment Situation Report. Also, we can't overlook the newly seated Congress either. Lord knows that group will be stirring up some commotion re: budget deficit.

For now, because trading conditions are still illiquid and investors are still shaking out the cobwebs, tactical considerations remain the primary (un) inspiration for market participants. We expect to see choppy price action within a wide, yet well-defined range. 

This means benchmark 10s could move as low as 3.27% or as high as 3.50%...our profit taking target is 3.31% once 10s cross through a cluster of resistance around 3.36/37%. 3.27% is where we see a pre-NFP stalling out (unless the market frontruns after a weak ADP print).

For Fannie 4.5s, the price range that corresponds with 3.27 to 3.50 yields in 10s is 101-10 to 102-10. However when looking at the chart below you'll notice the FNCL 4.5 is already bid over 102-10. This indicates current coupon MBS are a bit rich vs. their benchmark guidance givers, so we should expect loan pricing to lag into a TSY rally. Well actually..we should say lenders probably won't be offering much improved rebate until a rates recovery rally is confirmed with econ data on Friday. 4.875% is Best Execution in C30 paper. 4.75% for FHA but the primary mortgage market is very segmented so some best ex quotes will be higher (coughRETAILcough).

MBS outperformed 10s last week thanks to month end bargain buying and a violent bounce in benchmarks away from 3.50%.  Without a substantial shift in fundamental investing perspective, it makes sense that we'd see some MBS profit taking (basis) as TSYs chop around the recent range.

Plain and Simple: barring major NFP frontrunning, we don't anticipate much movement outside the recent rates range ahead of the Employment Situation Report on Friday. That doesn't mean loan pricing will be stable though. The potential for volatility remains high. Beware of multiple intraday reprices as benchmarks whip around a WIDE, yet well-defined range.

Current Market...

Benchmark TSY and "rate sheet influential" MBS coupon prices moved sharply lower on the open. 10s ventured as far as the post 7-year note auction rally pivot at 3.40% before short covering picked up (just as it did last Thursday to HOLD THE LINE) and 10s caught a bid. This began in advance of the ISM manufacturing report and extended after the market learned the Manufacturing Employment Index dipped to a 9 month low in December.

RTRS-ISM U.S. MANUFACTURING PRICES PAID INDEX 72.5 IN DECEMBER (CONSENSUS 70.4) VS 69.5 IN NOV
RTRS-ISM REPORT ON U.S. MANUFACTURING SHOWS PMI AT 57.0 IN DECEMBER (CONSENSUS 57.0) VS 56.6 IN NOV
RTRS-ISM U.S. MANUFACTURING EMPLOYMENT INDEX 55.7 IN DECEMBER VS 57.5 IN NOVEMBER
RTRS-ISM U.S. MANUFACTURING NEW ORDERS INDEX 60.9 IN DECEMBER VS 56.6 IN NOVEMBER
RTRS-ISM U.S. MANUFACTURING ACTIVITY INDEX AND PRICES PAID INDEX AT HIGHEST SINCE MAY 2010
RTRS-ISM U.S. MANUFACTURING EMPLOYMENT INDEX AT LOWEST SINCE MARCH 2010

10s and FNCL 4.5s are making a comeback. 10s are now only down 12/32, yielding 3.334%. FNCL 4.5s are now only -4/32 at 102-16 after falling as far as 102-11.

Volume picked up a bit into the rally as more shorts were covered ahead of the Fed's latest QEII POMO in the long end of the curve. It seems like that event has been the primary motivation of the originator friendly bounce we're experiencing at the moment. With liquidity still largely lacking it would not surprise me to see 10 yield yields chop higher again, which would push MBS prices lower.