MBS CLOSE: Perspective

By: Matthew Graham • Mon, Jun 8 2009, 5:41 PM

The day was not good as can be seen in the chart of the intraday price movements:

This was good for a 26 tick loss in 4.5's bringing the price to 97-14. Keep in mind though that negative convexity severely saps these lower coupons, so 5.0's performed much better by comparison, "only" losing 15 ticks. To illustrate just how much of an "Up In Coupon" (UIC) day it was, 6.0's and 6.5's were both actually positive on the day. As always, go to the PRICE PAGE for a full run-down of MBS prices.

Several factors combined to drive prices down today:

The "S" word is an omnipresent thorn in our side. No matter how well the markets try to prepare for treasury auctions, it seems that SUPPLY continues to do damage until the next time it is mentioned. Since there have been no "breaks" when you consider either auctions or the announcements thereof on a week to week basis, supply--whether actual or feared--is central to the current plight of all things bond related. So one of the horseman today was that mere "omnipresence" of supply. In other words, notwithstanding tomorrow's 3yr auction ( a bullet point unto itself), the general atmosphere of supply--some this week, more on the way--is a pervasive invisible force that makes market participants "forget" they already knew it was coming, thus pushing trader's fingers towards the "sell" button as if the announcement broke 5 minutes ago. It's a very general and somewhat puzzling, but very big problem.
Specifically with respect to supply, no one wants to get caught with their pants down as the auctions start to hit tomorrow with $35 bln in 3 yrs. So position-taking plays a role.
Moving on to "Fear And Sillyness..." Fed funds futures are starting to price in higher and higher liklihoods of rate increases. You read that right: Increases! Talk about a paradigm shift for market bears so satiated with bond allocations! Who could imagine having to deal with rate hikes after the orgiastic feeding frenzy in fixed income?! Threatened with the prospect of current yields looking "silly" in a few months is not a promising prospect for little Johnny Tradesalot. If one puts much stock in these farcical futures numbers, best to sell I suppose...
Ongoing speculation on one of any number of iterations of the "what if things really do recover this quickly" disease. Some speculate the Fed will hike rates as mentioned above. Perhaps even worse, some are now speculating an early abandonment of the treasury and MBS purchase programs. Why buy more if the economy continues to recover right? I think someone said something about a paradigm shift? Are we REALLY talking about a self-sustaining recovery in the face of rising rates and the crippling of a housing recovery? I mean, I guess "we" are, but if I got to simply choose topics that would matter in retrospect a year from now, these topics wouldn't even make the list.
Volatility... We've talked a lot about this recently and we're in good company. Vols are really ticking up. No matter which direction a period of high volatility is leading, it's not good for duration. This is the simple nature of volatility: If I don't know where things are going to end up, why would I want to take a long term bet? Just another reason for the kicking duration off the island over the past few weeks.
Perception that the Fed is "sitting on their hands" as bonds execute a 10 point death spiral... More on that in a moment... But as for selling pressure, the longer the Fed let's yields back up, the more one might think, "maybe they won't do anything?! Oh No! Maybe I shouldn't be thinking it's the Fed's job to "let" or "not let" things happen in the first place?!" Talk about paradigm shifts! Is there an echo in here.
Late Stock Rally kicking bonds while they were down. It looked something like this and further compounded the "fear of green shoots:"

And the above chart, in and of itself, could be labelled as another cause for MBS specific weakness today, in the sense that we're still a slave-as-always to the yield curve. In other words, not much inherent weakness in MBS... We just have to follow the guy who thinks he knows what the flavor of the month is going to be for the rest of the year. Evidence from relatively flat spreads on the 5.0 MBS versus the 5yr tsy over the past two days:

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Ok, take a breath.... If you're doing just fine in this market either because you already have the perspective you need or because you locked most of your pipeline last week or before, you're free to go... All the rest of you, feel free to forget all of the above and start paying attention now. It's so important that we keep some PERSPECTIVE on weeks like the last few. "Wish you would step back from that ledge my friend..." Don't get me wrong, if you were floating your whole pipeline over the weekend, you're in bad shape, but not unrecoverable. If you haven't already, make sure your GUT-FLOP is dialed in and assess any holes in your personal plan. I'd originally wanted to go into broader detail on perspective today, but I got caught up in charts and found something for you to chew on that will hopefully generate a measure of perspective on your side of the table, thus allowing us to go farther and deeper if we do get to a more robust discussion on "post-pipeline-catastrophe game planning." In other words, consider the rest of the post, and we'll come back to damage control after you're up to speed on the following...

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Technically, Overhead Resistance, Once Broken, Becomes Support

We DID NOT break support on 5.0's today or even the 4.5's. If the green line were to go below the green dotted line or the red line below the red dotted line, that would be much worse than our current position. The fact that we stopped exactly on the green line and began to greatly decelerate losses once we reached that range is evidence that this technical level may be in play. If it is, and if we stay above it over the next few days, it's good upside potential. BUT!!!!!!!!!!!!! Even IF WE BREAK IT AND THINGS LOOK LIKE THEY'LL GO LOWER, THIS STILL BENEFITS YOU! It's the same as a stock trader who knows prices are going down. He or She can short the market. If you know general directional probabilities ahead of time, you can benefit in the same way.

Two Steps Back Now.

Sure, today makes things look bleak against the backdrop of 2009, but what happened before then?

Well, that's a start... At least it shows we've coped with similar volatility in the past and bounced back, not to mention we're still higher than any point in 2008 or 2007. But wait, let me take you back, way back.

This is the most important graph I've ever uploaded to this site. Well... It will be in a moment...

I chose to make the 10 yr chart a 5.5 MBS because it's more "middle of the road"--high at times, low at others, but with the exception of the early part of the decade, our best bet for volume and closeness to Par. So why is it so damn important? I'd love to talk a lot more about it, but also want to make this post short enough (ha!) that it will get read. So I'll give you the markup now and a brief discussion below:

Here's what I see....

I see a boom (for RATES not STOCKS!) in bond prices following the tech bubble in early 2000's. This played a role in stoking the refi boom beginning as these prices peaked. The boom held a "channel" between highs and lows. (this would look a lot flatter, like the following two, in higher coupons by the way. We could and might address this with a YIELD chart of the FNMA "current coupon"). In the next phase, stocks rallied, and MBS didn't sell quite as much as they probably should have which some might argue was a component of the meltdown (rates too low for too long). Regardless, the same range of channel was held.

The final set of upward sloping yellow dotted lines is where the problems begin. The tolerably range-bound, mostly-seasonal directional fluctuations of prices started to break rules. First we see a stark visual representation of the meltdown. Despite a market trending in their favor, MBS could not hold the bid. In mid 2008, when it looked like MBS "should" rally into the winter, they fell below the trend. If you're the Fed watching all this, you might have this MBS purchase plan ready to go "just in case," but as long as that trend can hold without your intervention, best to not get involved. Woops! There it goes, we broke the trend! Well guess when the buying program was announced... you got it... Immediately following that trend break. Look folks, this isn't CAUSALITY, I know that, but I am saying it's more than coincidence and even pushes confluence a bit.

The main reason for the previous thought is what follows... MBS shoot up at a record pace to record prices AND with record spread tightening. MBS's blushing bride (the markets, the fed, whoever...) is left with the cliche: "this is all so, so sudden." The "higher high" trendline that connects winter 06-07 highs with winter 07-08 highs (thereby suggesting our recent highs) is violated a few weeks back! If it the violation didn't either stray to far from the trend OR (and here's the important part) didn't immediately follow a trend violation on the downside, this might not be such a big deal. But alas, a big deal it is.

Here's the bottom line...

You can answer the question in the graph however you want, but if I'm the fed, I take a step back right now (right now being the last few weeks, not necessarily the upcoming ones) and say as long as we stay in the uptrend, as long as the markets appear to be getting "less bad," as long as spreads stay stable, our job is done right? I mean, we're imminently READY to act if prices fall below a certain tolerance level in this uptrend, but I (still in Fed persona) think it might be TOO aggressive and possibly unsustainable to artificially keep MBS prices operating above the uptrend. <end fed persona>. So there you have it. If economic indicators are improving and MBS prices are not even to the midpoint of their uptrend, why jump in now and risk doing damage by "overcooking" the rally with artificial heat? (that was fed voice again, not mine).

Here's MY voice:

There's a lot that isn't considered about that point of view which we've run out of time to discuss. But I think it might be a very perfect graphical representation of why we haven't seen more action--why we have felt "abandoned" by the dad that helped us get moving without training wheels. Ha! They think our buddies and us might actually ride to the end of the block unharmed!? Even though they probably know better, this may simply be the part they have to play. I don't think we, or our buddies (tsy's and stocks) will have any problem showing showing dear old dad just what 3 different--yet equally suggestive of fatherly action--crashes look like. Let's hope we aren't skinned up too bad and that dad gets over here quick enough. Or friend 3 (stocks and economic optimism) could fall so hard that we might just keep riding! Either way, something's gotta give. And it will. 2 out of 3 eventualities bring rates back down. Even the third which might seem like the end of the world (the economy really does recover, rates get higher, stocks rally), could be viewed as a positive under the context of, uh, I can't think of a good way to describe my thought here.... Let's just call that one a "paradigm shift."