Directional MBS Alert: Bond Market Builds Case for Lower Rates
The bond market seems to be in the midst of technical shift in its underlying technical bias, from bearish to bullish.
We've observed much short covering since last Thursday, a behavior we started looking out for on February 11th as a potential forward-looking indicator of lower rates to come. This is what we wrote...
"Short covering rallies aren't our favorite because they don't necessarily speak to organic strength in bonds. But they do provide a hint of positivity. Short covering implies traders are nervous about their bearish positions. Short covering into sell-offs implies bearish traders are defensive of their profits. They are nervous rates won't move any higher. There's been more the rally than short covering though. Geopolitical undercurrents are also exerting their effects on markets."
Calling out short covering was motivated by the fact that our technical sell-off target of 3.70% was hit by the 10 year Treasury note. We viewed this inflection point as the first major support level following a bearish range breakout that occurred after the January Employment Situation Report. Since February 11th bearish momentum has gone sideways, trader positions (short vs. long) have begun to balance out, and stocks have hinted at a long overdue retracement and led to a headline driven flight to safety into government bonds.
These are signs of a potential turning point for interest rates, but not an all-out float alert. Real money investors have approached this directional move cautiously because it requires a strategic shift in hedging bias. We witnessed real money buying today in HEAVY FUTURES TRADING VOLUME, so signs continue to favor a shift in technical bias from bearish to bullish. But we must ALWAYS remain defensive of interest rate rallies. Bond math only allows so much movement before a greater commitment is required to extend the rally. Rates always move higher much faster than they move lower. Loan originators are all too familiar with that statement. And we freely admit, there is much technical resistance ahead. So, in that light we are not ready to offer a timeline or detailed guidance. All we can say is we see the right signs. The stars are aligning. JUST LIKE THEY DID LAST YEAR AFTER FOUR MONTHS OF BEARISH MOMENTUM WAS WASHED OUT OF THE BOND MARKET (civil unrest! Remember Greece was the catalyst last year).
These observations provide a bullish backdrop for our longer term call: Brighter Outlooks or Year End Volatility? Watching the Bond Market Repeat History.
Remember this chart? 3.31% is our next target if 3.42% is broken.
Plain and Simple: We are cautiously optimistic about lower mortgage rates in the months ahead but remain quite defensive of the modest loan pricing improvements that have been awarded since last Friday. This is only a directional alert. We are in the midst of a potential reversal, the move is still immature. More positive progress is needed to confirm a shift in technical bias. The risks of floating still include a sharp spike back up to 5.25% in the "Best Execution" C30 mortgage rate.