Bond Expert: Thursday Wrap

Prices of Treasury coupon securities surged today as waves of spread product buying and some Treasury buying propelled prices higher. Economic data released today, on balance, supported the theses that the economy remains quite sluggish. Additionally, today is the day on which the Treasury pays off maturing debt, pays interest on other debt and settles the refunding securities which they offered last week. The net effect of that flow of funds is a gigantic pool of money needing a home. (I am time pressured as I write today and I do not recall the exact size of the pot of money seeking sanctuary. It is something in the$50 billions or something on the $70 billions. I guess I killed too many brain cells in the 1960s.)

The yield on the benchmark 2 year note has declined by 8 basis points to 2.43 percent. The 5 year note was a superstar today as its yield dropped 10 basis points to 3.09 percent. The benchmark 10 year note watched its yield drop 10 basis points, too, and it is finishing the day at 3.82 percent. The Long Bond lagged the crowd as its yield declined by only 7 basis points and is closing at 4.55 percent.

Spread product was in vogue again today. Swap spreads are tighter by 4 basis points to 5 basis points. Agency spreads are tighter by 2 basis points to 5 basis points. And a hypothetical current coupon mortgage bond is 5 basis points tighter versus the 10 year Treasury.

Dealers with whom I spoke reported significant buying across the wide universe of spread product. As dealers got lifted out of paper it creates a need for them to buy something to hedge the sale. I believe that the spread product buying engendered the rally in Treasuries.

What has prompted the buying? I had a conversation with a trader yesterday and with a portfolio manager today and each of those conversations illuminates and informs regarding the race to lower yields.

The trader with whom I spoke yesterday is a maven of the repo market and breakeven spreads. For the uninitiated, bond dealers don’t pay cash when they purchase securities; they borrow in the repo market and fund themselves with borrowed money. There is positive carry and there is negative carry. Positive carry earns a dealer money each day as the yield on the underlying security exceeds that rate at which the dealer borrows to fund itself.

Yesterday, this trader noted that the 2 year note was exceedingly cheap when one looked at the funding cost of the issue. When he and I spoke the issue yielded 2.55 percent. In the repo market one could borrow money out and fund that purchase to December 31 at a repo rate of about 1.60 percent. According to my friend, the positive carry generated would have been the equivalent of owning the bond at a yield of 2.93 percent. Then if one makes the assumption that the shape of the yield curve will be the same in December as it is now, one has to factor in the roll down the curve as the 2 year note would be approximately an 18 month security at that time. The so called rolldown is worth about 17 basis points. Add that to the 2.93 percent we derived earlier and you have a breakeven yield of 3.10 on December 31 2008. So if the security yields less than that you have earned a few shekels.

I spoke to another former client who manages Treasury and agency money. He noted that he was an aggressive buyer of 18 month agency paper yesterday at a yield of 2.80percent. He bought more today at lower yields. He engaged in a similar analysis. He compares the yield on the bond to what would result if he rolled repos over the same term. He said that unless you make some very silly assumptions (such as the FOMC begins a series of 50 basis point rate increases in September) there is no scenario in which remaining in repo is better than owning the 18 month agency.

He makes the salient point that when the FOMC finishes an easing cycle they generally remain on hold for quite some time. He noted that following the Russian default in 1998 they remained on hold for 7 months before they raised rates. Following the aggressive ease which took the funds rate to 1 percent in 2002, they waited 12 months to act and following a round of ease in 1992 and 1993 funds were fixed for 17 months before they raised rates.

The point is that since the financial markets are mired in the worst financial crisis since the Depression, it is most improbable to believe that the Fed will do anything other than leave rates right here. To suggest higher short rates would disturb the very fragile equanimity which has only recently returned to the market.