Bond Expert: Wednesday Wrap

Includes: TIP, TLO
by: John Jansen

Prices of Treasury coupon securities are reacting rather violently to the statement by the FOMC at the conclusion of its meeting. The Committee in its infinite wisdom retained the “extended period of time” language, and that has anchored the front end and has motivated a shift in the tectonic plates which undergird the long end of the Treasury market.

For the day, the yield on the 2 year note is unchanged at 0.91 basis points. (For the record it is 257PM as I begin to compose this missive.) The bifurcation word which I employ works again today. The carnage is significantly worse the further out along the yield curve that you are. The yield on the 3 year note has edged higher by 2 basis points to 1.45 percent. The yield on the 5 year note has increased 4 basis points to 2.40 percent. The yield on the 7 year note has soared 7 basis points to 3.11 percent. The yield on the 10 year note surged 8 basis points to 3.55 percent. The yield on the 30 year bond has catapulted 10 basis points to 4.42 percent.

The steepening since the FOMC announcement is dramatic and swift. The 2 year/10 year spread was 256 basis points in the moments before the FOMC spoke. It is now about 264 basis points.

Similarly, the 2 year/30 year spread was 342 basis points just prior to the FOMC; now that spread is 351 basis points. For the record, I believe that the widest spread ever recorded was on October 5, 1992, when the 2 year note yielded 3.60 percent and the Long Bond yielded 7.29 percent. Luca Brasi would have haltingly referred to that as a masculine yield.

What is the motivation for the movement in the yield curve? Certainly some of the flight from the long end is a belief or feeling that the FOMC is abandoning its job as a “bond vigilante”. However, I always prefer to look to the next trade, and the next trade is a rather gargantuan duration drop by the Treasury and the taxpayers with the offering of $25 billion 10 year notes and $16 billion Long Bonds. In my view the principal motivating factor is the dealers' desire to shoot the taxpayer in the big toe and pad the bonus pool into year end. Pretty simple stuff, I think, and devoid of cosmic implications.

Other markets are also rejecting the action of the FOMC. TIPS spreads are at their widest levels of the year. Prior to the announcement by the FOMC 10 year TIPS had last traded around a 209 breakeven. That spread in a recent quote was 211 bid without an offer. In a similar fashion, the 30 year TIPS had traded at 229 1/2 earlier and that issue was 233 bid without an offer.

The performance of that issue is even more striking in light of the news today that the Treasury will bring 30 year TIPS back for an encore and abandon the 20 year sector. I think that there is a strong probability that the Treasury will issue more than two 30 year TIPS per annum as those who manage debt issuance seek empty maturity buckets to fill with Federal Government paper.

The announcement by the FOMC also decreed that it would reduce its purchases of agencies to $175 billion from the previously announced $200 billion. There is nothing sinister or nefarious afoot here. The agency market lacks liquidity and that paucity of liquidity derives from the Brobdinaginan purchase program of the Federal Reserve. One analyst noted that the Federal Reserve owns between 25 percent and 50 percent of many agency issues and that concentration in the hands of one player has made some end user clients reluctant to play in the agency sandbox.

Agency spreads widened initially by about 5 basis points following the news.

I think that if there was some significant spread widening episode, the FOMC would quickly rethink this plan and would act to back stop spreads.

In addition, I think that this is a minor bone to throw to the inflation hawks as it is a concrete sign that the Federal Reserve is acting to reduce its footprint.

I have heard of some active sellers today. There were leveraged sellers of 2 year notes early in the day as some active traders believed that the sale was a free option on the FOMC statement. The logic was that if the FOMC left the language unchanged, the short would go against the seller but not in any meaningful ways.

There have also been chunky sellers of TLGP bonds guaranteed by the FDIC.