MBS RECAP: Another Afternoon Recovery

Following a strong 3yr Treasury note auction, trading action has evolved in a more positive manner for MBS and Treasuries. Fannie Mae 30yr 4.0 MBS coupons are now +1/32 at 101-03 while 4.5s are +2/32 at 104-12. This positive price action has already resulted in one report of a reprice for the better. More should follow if MBS continue rallying.

Treasury just auctioned $32-billion 3-year notes. Demand was strong for this issue, even at expensive prices. That is illustrated via an above-average "bid to cover" ratio, which came at 3.28 bids submitted for every 1 accepted by Treasury. This maintains strong demand in the last four 3yr note auctions. The high-yield produced by bidding in the actual auction was also 0.8 basis points below the 1pm "When Issued" yield . This is another sign of a strong buyer appetite. Dealers were the big winner in this one with a 55% award or $17.7bn of the $32bn offered. That is well-above average for primary dealers. Indirect accounts gave a little extra support as well with a 36% take-down. Directs on the other hand showed little motivation on all fronts. Based on the aggressive price bidding, even at expensive levels, it appears that primary dealers, the major supportive influence in today's auction, we're short 3-yr note inventory and needed to cover their "short positions" (or close flatteners/curve spread trades). We'd expect similar behavior in tomorrow's 10yr note auction. "Short covering" is when a bearish trader closes a position that was opened with the intention of capitalizing on lower prices/higher yields (or a flattener position). The term "short" describes the trader's directional bias. "Covering" simply means closing the position was closed.

Dennis Lockhart, president of the Atlanta Federal Reserve Bank, today spoke in support of an explicit inflation target. Lockhart said low and stable inflation is one of the underlying fundamentals that will shape the country's economic performance over the coming quarters and years. The concept of core inflation is part of the FOMC's policy discussion, not because it is an objective of monetary policy but because it is often an informative statistic. However, the objective of policy in the end has to be defined in terms real people experience—that is overall, or headline, inflation. This would include cost of living expenses such as food and energy. According to Lockhart, he would not hesitate to support an exit from the FOMC's current policy stance if he believed the headline inflation number of the past six months was indicative of the underlying trend inflation rate. He doesn't believe this to be the case. He said he is wary of tightening monetary policy in the face of quite ambiguous economic circumstances unless doing so is absolutely necessary to meet the FOMC's price stability mandate. The language the FOMC uses to explain its inflation forecasts can, at times, get in the way of effectively communicating its ultimate inflation objective. One way to deal with this tension (an approach employed by many central banks around the world) is to set an explicit numerical objective for inflation, also known as an inflation target. He supports the FOMC setting such a target. According to Lockhart, the specifics of an inflation target would need to be worked out by FOMC participants. But a few principles for an effective inflation target would be stating it in terms of some measure of overall, or headline, inflation and making it achievable over a realistic time frame. An appropriately constructed inflation target would not be in conflict with the FOMC's mandate to support employment.