MBS Live Day Ahead: Sights Set on 2020, Hoping For Low Drama Holidays

Based on volumes, liquidity, and most importantly, the calendar itself, there's a compelling case to be made for closing the book on 2019 as a trading year and picking things back up with 2020 developments.  Why would we throw away 2 weeks of trading and what exactly does that entail?

First off, the next 2 weeks (the exact amount of time left in 2019) will not be thrown away in the sense of bond prices' impact on mortgage rates.  If bonds tank, rates will still move higher, and if bonds rally epically, rates can still fall.  That said, major rallies will have less of an impact than they might in other months where more traders are trading more money, and where there's no apprehension about liquidity drying up even more in the coming weeks.

What is liquidity and why will it dry up?  If volume is the amount of money being traded at all price points, liquidity is the volume at any given price point.  For example, if traders are very interested in buying and selling a lot of MBS at a price of 101.5, but buyers complete dry up at 101.625 despite plenty of sellers, that's illiquidity.  There can even be cases where sellers ALMOST completely dry up at any price while buyers are plentiful.  With supply/demand 101 in mind, that leads to a quick, artificially strong rally in bond prices as the few remaining sellers can keep jacking up prices for the buyers that have needs to fill.

Of course this can work the other way as well, where there are only so many buyers around despite plenty of sellers.  If those sellers have compulsory needs to offload those bonds, the few remaining buyers can quickly drive prices through the floor.  The bottom line on illiquidity is that it can exaggerate imbalances in either direction.  And without imbalances, it will simply restrict the range.  More on illiquidity in this primer.

The other topic to keep in mind when it comes to throwing away the last half of December is the fact that traders are people too (there's primer for that one as well).  Simply put, even in this day and age where we hear so much of the market is driven by algorithmic trading, etc., the fact remains that removing even a small percentage of key players from the bond trading world has a profound impact on liquidity and volume.  Moreover, there is a lot of embedded "holiday culture" in the bond market where traders simply assume that other traders are operating in holiday mode whether they are or are not.  That tends to pull forward a lot of the volume that would normally take place in the 2nd half of the month and it's one of the reasons we saw almost 3 million 10yr futures contracts traded on Friday when a normally healthy day is 1 million contracts.

That insanely high volume occurred on a day where yields were basically testing the top end of the current range (1.95% despite some overrun in early November).  In "hoping for low drama," we're hoping to see bonds simply hold under 1.95% into the new year.  At 1.875 currently, and with the 1.86% ceiling at risk of confirming a breakout today, that's by no means a guarantee.  The frustrating thing about all this is that a breakout of 1.95% may or may not be vetted by early January trading.   Between now and then, momentum could be dictated far more by illiquidity and year-end trading needs than by the econ data.  We can watch the small uptrend in rates (white dotted line), and hope for it to break and give way to boring trading into the New Year holiday.  Otherwise, we're on guard for a break above 1.95%, which could indicate a bit of a predisposition among traders in 2020.