MBS Week Ahead: Why It's So Scary

The European-led move lower in yields that began in early 2014 was like nothing we've seen in more than a decade. In terms of the market momentum it created, it was a wave that was too big to consider swimming against. It arose from the introduction of quantitative easing in Europe, which means the European Central Bank (ECB) was finally able to buy sovereign debt of individual Eurozone countries. Critics thought this would never happen. It remained a divisive issue through most of 2014, but when markets began seeing the writing on the wall, that’s when the “piling into the camp” began. 

It was really a beautiful thing for those market participants who could read that writing, because it meant they could have ample opportunity to front-run the actual implementation.  Switches were increasingly flipping in traders' minds from "Germany will never allow European QE" to "maybe Draghi can pull this off after all!"  As inflation and economic data across the Eurozone continued to slide, it became increasingly clear that QE was the only bazooka left to be fired.

As more traders awoke to the inevitability, the momentum only increased.  Lower yields...  Lower Euro... And all the while the Fed was in the process of tapering and had begun talking about rate hikes, thus strengthening the dollar and adding to momentum in the Euro sell-off. 

When I say it was like nothing we've seen, I'm referring to the linear abandonment of all hope, as seen in the form of plummeting bond yields in Germany (the benchmark for the Eurozone), and the extended time frame over which it happens.  Nothing since late 1998 has caused yields to drop in such a straight, determined line for that length of time.  Realistically, even 1998 looks volatile by comparison. 

This shape of trading (seen in the first part of the teal section below) is the sign that everyone was on the same page with the EU-led bond rally. 

The second part of the teal section shows that everyone is now on the same page about moving in the other direction.  It even appears to be reading from the US QE playbook where the beginning of asset purchases has a "reflationary" effect.  In other words, look at the QE1, 2, and 3 time frames.  While QE wasn't the only market mover at the time, all three QE's saw yields generally rise during their tenure.  It was the same with EU QE.  Purchases began in early March and yields began rising in mid April.

But "beginning to rise" is one thing.  Instead, we have the first correction to one of the most stunning, forceful, and long-lasting bond market rallies in history. And it's too soon to say or think that it's over.  That's why it's so scary.  

With that big picture as a backdrop, markets continue to go about their day to day lives.  This week it's a Treasury Auction cycle and a few moderately important economic reports concentrated on the last 2 days.  Markets have bigger things to think about.  If it was only about the data, things might not be so volatile.  When one of the biggest bounces in bond market history remains up for discussion, every day's an adventure.