MBS Live Recap: Bond Rout Continues With No Help From Month-End

There is month-end bond buying and then there is month-end "position-squaring."  These are 2 different things.  Month-end bond-buying refers specifically to the phenomenon of money managers adjusting their holdings to match a specific bond market index.  In general, there's always a need to add to bond holdings because there's always a certain amount that will be maturing in any given month.  That's why another name for month-end buying is "index extensions" (because average duration of any given set of bond holdings must be re-stretched or "extended" every month, lest the portfolio gradually pay itself down to nothing. 

Index extensions always bring in some bond buying near the end of the month.  Position-squaring, on the other hand, can happen any time, but has a bit of extra motivation near the end of the month and especially near the end of a quarter.  This simply refers to "open trading positions that need to be closed."  It doesn't apply to every class of trader out there, but when there is an overabundance of traders with the same sort of position (long vs short), any big shock that pushes those positions into less profitable (or unprofitable) territory can cause a snowball move in the direction of the shock.

In this week's case, we had the ECB headlines on Tuesday (Draghi alluding to tapering) causing a negative shock for bond markets.  With German Bunds losing nearly 25bps to US 10yr yields losing "only" 18bps, there's no debate about the initial source of inspiration.  But whereas European bond losses managed to hold their ground fairly well on Wednesday and Friday, US bonds continued to weaken.  Friday afternoon's move was particularly abrupt when compared to the calmer morning hours.  

That abrupt weakness was all about the liquidation of the long positions traders had been accumulating in recent weeks.  This thesis is further supported by the fact that bonds weakened after this morning's PCE data, which could have been used to justify bond buying on any other day (core annual PCE--the thing the Fed would like to see at 2.0%--fell from 1.5 to 1.4%... not exactly a great reason to sell bonds).  Bottom line, we got hit at the end of the week from this snowball selling.  This improves our odds heading into next week, but there could be longer-term liquidations yet to come if today's supportive levels are taken out.  (Translation: 2.305% is a major technical ceiling in 10yr yields.  If it's broken, it could be a cue for more traders to liquidate longer-term bets on lower rates, thus prompting another few days of snowball selling).