The Week Ahead: Setting the Tone for 2nd Half of 2013

The theme of "honing in" is everywhere in financial markets and in the universe beyond.  It goes by many names and can be thought of in many ways: a plucked guitar string returning to stillness, a driver regaining control after swerving to avoid a road hazard, Goldilocks' acquisition of the "just right" porridge, or even planets in orbit around a center of gravity. 

In all of these examples, the progression of events isn't always as simple as narrowing down options by eliminating the extremes.   The guitar string can break (or be plucked again!); the driver can over-correct and crash; Goldilocks could be eaten by a bear; and even orbits--given enough time--will eventually expand or contract, or will be affected by something else (like the sun swelling enough to engulf the earth in about 5 billion years - maybe).

The common thread here is that the "honing in" theme comes with other implications.  Patterns and trends may offer some measure of predictability (it would be easy to pluck a guitar string 100 times and measure the distance of the string vs its midpoint over time in order to predict how it would behave the next time it's plucked).  That would be the calmest end of the spectrum of possibilities and the easiest to predict. But again, the string can break (hard to predict exactly when that will happen!); it can even degrade and behave differently; or if we want to get serious about exploring the other end of the calmness spectrum, a 2 ton weight from Looney Toons could land on you and your guitar.

That's how bond markets feel sometimes--especially for those of us whose ability to thrive seems overly tied to outright trading levels in one small section of the market.  For mortgage market participants, if May and June of 2013 haven't been a 2-ton weight, they were at least enough for a broken string or 2.  But if we zoom out to the bigger picture, things are much more like the higher probability scenarios characterized by "gradual contraction or expansion."

With that in mind, this week's FOMC events (1. The official Announcement, 2. Member Forecasts, 3. Bernanke Press conference, collectively referred to by me as "FOMC Events," or "FOMC Festivities"), are more likely to confirm the current tone of "moderately expanding trading ranges" in bond markets.  Thankfully, it looks like we're grinding around a higher section of yields (though I'd caution that we're talking about very long term trends, so it's not necessarily safe to infer "rate ceiling" from this assessment). 

The less mainstream (but still possible) outcomes would be that the FOMC Events act to nudge us off the more mainstream course.  The following charts attempt to explain this, first, by pointing out how yield movements have evolved in similar ways in the past, and then by zooming out a bit further and considering hypothetical paths for the future.

Essentially, the 2003-2008 range looks a lot like the 2013-2018 range might look in the absence of any major surprises.  In considering "most mainstream" outcomes, it essentially means that an extremely bond-market-positive response this week could merely motivate a move from the higher side of the mid-2012 - present range to the lower trendline, but that it would take a surprise of some sort to break below the "tepid drift" range.  On the other side of the coin, we'd hope that the most-negative result for bond markets would merely see the tepid-drift range pushed and prodded on the high side, while anything above would take a similarly-sized surprise.

All the action is on Wednesday starting at 2pm.  All three events stand a chance to be critically important.