Bond Expert: Thursday Wrap

Prices of Treasury coupon securities surged rather dramatically lower today with the most significant adjustment occurring in the front end of the Treasury curve. For much of the day in the front end if it was not tied down ,someone was selling it. All manner of accounts were either outright sellers or unwinders of curve trades. So the yield on the 2 year note has catapulted 14 basis to 2.10 percent. The yield on the 5 year note has climbed 8 basis points to 2.89 percent. The benchmark 10 year note yield has gained (I guess that is like gaining unwanted pounds) 4 basis points to 3.72 percent and the Long Bond yield is 3 basis points higher at 4.52 percent. One of the significant casualties of the day has been the 2 year/10 year spread which has narrowed by about 10 basis points to 162 basis points.

I have received some e mail inquiry about something I wrote in an earlier post in which I suggested that the money market curve would steepen out as the perception that the Federal Reserve had completed it easing cycle gained currency. The corollary question regards the shape of the Treasury curve in that environment.

I think I have to answer the question with a bow to the economists of the world and suggest that my response is of the famous “ceteris paribus” variety. If we start when the easing cycle begins, the playbook for money market customers (defined here as investors who traffic mostly in maturities of one year and less) is to race out the curve and grab the still higher yielding securities to lock in those yields. In a typical cycle, as the Fed eases serially, the investor would want to own the higher rates . If the investor owned a shorter instrument then they would face the prospect of reinvesting at the new lower Fed inspired rate. So in money markets the curve will flatten from the back versus cash as investors lock in yields.

When one ventures out the coupon curve (maturities of 2years and greater) the cycle plays out somewhat differently. All yields will drop but the drop in yields is greatest in the 2 year note and that accounts for the steepening of the yield curve. There are a variety of reasons for this. The 2 year note is the coupon security most directly tied to the cost of funds and so it will move in lockstep with the funds rate and often times will move in advance of the Fed as it anticipates the next rate cut. For some small portion of players in the front end the 2 year note is their Long Bond and their desire to lock in a rate in a high octane way will fuel some demand for the issue.

Why does the coupon curve not flatten as the Fed eases in the same way that the money market curve does? If I can indulge in some hyperbole to make the point, the 2year /5 year curve would flatten if enough investors believed that the easing cycle would last multiple years. Against that background ,investors would have an incentive to grab the longer instrument. I can not recall the Federal Reserve easing for a period of 5 years so that flattening does not happen and the curve will steepen between the 2 year note and the longer coupon securities.Since the 2year note is most responsive to moves by the central bank it takes on a staus as the anchor for many curve steepening trades by hedge funds,central banks and money managers. They pile into the issue en masse.

So as the ease cycle draws to a conclusion money market investors do not wish to be caught with a surfeit of longer dated money market paper. Similarly, investors will shun the 2 year note as the rationale for holding the issue is no longer quite so transparent. In that instance we have trades such as today where those who hold the 2 year note as an anchor felt compelled to exit those trades. So against this background there will be a steepening of the one year and in curve and a flattening of the spread between the 2 year note and longer dated issues as it becomes apparent that the central bank has finished its work.

There is another interesting phenomenon in the so called butterfly trades which many traders love. There is a very directional quality to those trades and the belly of the butterfly will outperform the wings in an extended bull market. So in that environment, it pays to own the 5 year against the 2year and the 10year as well as the 10 year against the 5year and the bond.

When the market turns south, however,the belly lags and the wings outperform. I believe that the convexity hedging activities of MBS accounts explains a large chunk of that price movement but I will save that for another day.

Spread product has tightened significantly today . Agency debt has tightened by 7 basis points to 10 basis points and dealers report huge buying by foreigners. Traders report that GSE paper has decoupled from Libor and has richened dramatically to swaps. Agency paper in the 10 year sector at the height of the market meltdown traded as cheap as Libor +44 and had a wide close of Libor +41. That paper today is closing rich to libor for the first time since January. Agency debt in the 2 year sector is trading Libor less 30 basis points. One veteran trader noted that if one stops the calendar at July 2007 and marches back to 2002, then agencies, broadly speaking, traded Libor less 8 to Libor less 16. So todays levels by those standards look rich. They might not be rich and might be signaling the depth of some funding problem someplace in the world.

Mortgage paper traded tighter as did corporates.

I run on and apologize.

Comments

[jackooo]

The butterfly trade? I prefer the gypsy moth trade where the body is following the upper left wing and the legs are inversely proportional to the larvae which is coming in December.
Witchcraft! Isn't it great?