The Day Ahead: Fiscal Cliff Headlines Have Bond Markets on the Ropes

Last Wednesday, we characterized the impending FOMC-related events as "the best chance in almost a month to see more than 5bps of movement in 10yr yields."  Not only did that last Wednesday deliver on that risk, but so did yesterday.  While last week likely had most to do with the FOMC events, the current week is now clearly all about the Fiscal Cliff.  Almost out of nowhere, the laughable and pathetic political posturing has been replaced with tangible baby steps toward a common ground.  Whereas the Cliff seemed inevitable last week, there's a new found hope that it can be avoided as of Monday evening.

The first surprisingly progressive volley was fired over the weekend as Boehner floated a deal that actually had numbers.  This was a HUGE departure from everything else that had happened so far in that it WASN'T merely a staged hurling of insult and argument from an ideological cannon with a giant-sized wheel on the righthand side.  The White House's response was similarly ground-breaking in the sense that it didn't simply attempt to throw cold water on the deal, instead noting a sense of progress.  PROGRESS?!  Is that even allowed in Fiscal Cliff negotiations?!

That rhetorical question looks to be the primary driver for Monday's bond-market sell-off and equities rally, which marched with a pervasive, droning cadence that suggested some ominous underlying force at play rather than easily observed superficial data points.  This then, was a marked shift from "skeptical" to "listening" on both sides of the market.  MBS finally "got it," and capitulated to the sell-off.  But the new found tone of compromise and progress wasn't done for the day.

After the bell, Obama floated his own deal back to the GOP.  Shockingly, this one also had specific numbers and facts and obviated the need for The President or one of his staffers to take the podium with wastefully political posturing.  If things AREN'T CHANGING, then both sides have really upped the ante in terms of acting and role-playing.  For now, markets are buying into the shift in tone.  Markets say these guys seem more serious, more conciliatory, and perhaps more likely to avoid a full-speed Thelma and Louise re-make. 

Between the stronger NFP on the 7th, FOMC on the 12th, and the Cliff headlines so far this week, it's been a long December for bond markets, and there's reason to believe maybe this sell-off will be similar to the last few.  The chart below shows the overall sell-off since the 7th as well as the past three occasions where 10yr yields have closed over 1.75.  In all three cases, yields hit at least 1.835 before returning back to 1.75 (fwiw, the white line is the 200-day moving average). 

Sure... you could blur your eyes a bit, look at the preceding chart, and easily observe that this much-maligned sell-off is perfectly in line with recent gyrations, thus making a logically sound argument for a good measure of technical motivations during year-end trading.  But leaning on the evolution of the Cliff conversation is so much sexier, no?!  Epic decisions causing epic market movements!  (Ok... so the moves aren't that epic if you zoom out to a wider view, but we work with what we have at the time).

Is this the end of the low rate dream forever and ever?  Probably not.  Even now, we're merely contending with a move from 3.25% to 3.375% in Conventional Best-Execution.  But it's no fun at the moment.  Cliffy resolutions are definitely capable of causing a serious test of recent high yields, and while we wouldn't imagine that we'd face those prospects soon, both sides of the aisle are doing their best to convince us of that possibility before the ball drops in Times Square.

Economic data is relegated to "supporting role" in this environment.  It may exert some push and pull in the mornings, but will continue to be at the mercy of any sufficiently juicy Cliff headlines.  Today's econ is thin, with only the Q3 Trade Deficit (Q3 is soooo last quarter... Yawn...) and the National Association of Homebuilders Housing Market Index for December--interesting because it's housing-related, but not a major market mover.  The 5yr Auction goes off at 1pm, and 5's have been enough of a battleground maturity that this one is worth tuning in for, even if it doesn't end up moving the needle.  Barring unforeseen surprises in the data or elsewhere, the Cliff remains in focus.