MBS Day Ahead: What's the Recent Rally Really About?

The past two weeks have been good for bond markets, but the past two sessions specifically have been "weird good."  That is, they've resulted in much stronger price levels, but the reasoning offered has been stretchy at best (in that it's a stretch to believe it).  The most popular culprits in the saga of weirdness have been some report out of China that you've probably never seen or cared about in the past, and "emerging markets."

Neither of these things have ever been on the radar as probable motivations for domestic bond market movement.  If you're wondering "well, why now?" That's a solid question that too few seem to be asking (though that will likely change this week).  Let's get a head start on it...

First of all, HSBC manufacturing data for China.  Really?  It's not that the Chinese economy isn't a relevant cog in global financial markets, but a move just under 50 on this index is not only fairly uninspiring when viewed against recent results, it's also in line with the 5 month trend, not a first, and not a new low.  In other words, it's not the singular market-reality-altering event it's been made out to be.  Here's the chart, the source of the ostensible drama is the right-most bar.  Does that freak you out?

In an attempt to find freak-out-worthy stuff, the next subject of investigation is the "emerging market sell-off."  We'll look at the generic representative of the MSCI Emerging Market Index.  There is some correlation here between equities and Treasuries, but also some very troubling recent examples of things moving in completely opposite directions.  Is the red line in the chart below a satisfying explanation for the movements of the yellow line?

Let's step back a bit and look at a longer time frame for the same chart.  Given all the hullabaloo, you'd expect recent activity in the emerging markets index to look abnormally big, but it's actually the trading that's occurred inside the space of the white circle in the chart below that's supposed to accompany and account for the recent bond market rally.  Not only are there better places to freak out (see the lower section of the chart), but it's not even that big of a move, relatively.

Although it's not as visible in equities, there is certainly some panic out there, particularly in emerging market currencies (as can be seen in the chart below).  The chart below shows currencies for two of the countries that have come up frequently as a source of global financial panic.  There's not a great case to be made here for correlation with US rates other
than the simple generic observation that "panic somewhere" is driving
safe-haven demand for Treasuries.  The best thing you could say about
that is that if it's true, it's not doing a very good job of that
considering the magnitude of the movement in currencies.

Assigning causality to recent moves is destined to be an imperfect process.  Some parts of global financial markets have been moving far more than others and so they're getting the attention.  From there, questionable correlations have been making the rounds because reality is seldom so tidy and obvious. 

One glaring omission from most analysis has been last week's shifts in corporate bond issuance.  We can't ever be privy to big firms specific hedging strategies, but it's safe to assume that they're having an effect on Treasuries and MBS. 

Tradeflow considerations can never be ruled out.  In the current case, we know we have a big part of the financial community betting on higher rates in general.  When rates improve in cases like this, those bets can be forced to cover ("buy"), and a snowball rally of some unknown magnitude ensues.  Combine that with the corporate issuance shifts, a respectable stock sell-off, and some measure of global safe-haven demand (not enough to drive all the movement, but maybe it's helping), and we get a much more well-rounded sense of why things are happening the way they have been.