Bond Expert: Wednesday Wrap

Prices of Treasury coupon securities dropped today but the bifurcation of the market which began yesterday continued at an accelerated pace today. The declines in the shorter maturities were temperate while the longest maturities took a severe drubbing. (I usually write this later in the day around 330PM to 400PM New York time. I have an evening obligation so I am writing this about an hour earlier today.)The yield on the benchmark 2 year note has climbed 2 basis points to 2.39 percent. The yield on the benchmark 5 year note has increased by 6 basis points to 3.15 percent. The losses begin to mount in the 10 year sector as its yield climbed a double digit 10 basis points to 3.91 percent. The Long Bond should be quarantined as it is very ill. The yield on that instrument climbed 11 basis points to 4.57 percent.

The 2year/10 year spread widened 8 basis points to 152 basis points.

The 2year/5 year /30 year butterfly richened by a basis point to 66 basis points. That spread movement is very unusual. That spread is very market directional and a falling bond market should have cheapened the 5 year. The spread movement demonstrates clearly the enfeebled state of the bond.

It is also noteworthy that the curve steepened yesterday as prices rose and it steepened today as prices dropped. What does that mean? It means that investors want to get the hell out of the long end in any environment!

Why the carnage in the long end the last two days? I spoke to quite a few participants and the nearly uniform view is that Bernanke’s hands are tied and that with the financial system on the brink of disaster there is virtually no scenario under which the FOMC could raise rates. This group believes that with YOY inflation at 5 percent, a yield of approximately 4.50 percent is much too low for the Long Bond. If the Federal Reserve has embarked on an inflation policy of benign neglect, then many have chosen to reduce holdings of long term paper.

One trader noted that before Bernanke briefly became an inflation hawk in early June the 2year/30 year spread was trading around 225 basis points. Bernanke echoed some hawkish tripe from Trichet and the 2 year note yield jumped over 50 basis points from 2.40 into the 2.90s in just two days. The market is retracing that process as that spread is about 217 basis points at the current time.
I was unable to identify any of the selling as I made my rounds. I did find one bond trader who did see a host of buyers of the 25 year through 30 year sector at the high yields. He noted that many of the trades were modest but was impressed by the number of participants who viewed today’s yields as an appropriate entry point.

TIPS spreads in the 10 year sector have widened by 3 basis points to about 247 basis points. I would contend that that is an excellent performance by that asset class. The spread had narrowed to 234 basis points last week as part of the underwriting process for the 10 year TIP which Treasury sold last week. It has since moved to the current level in spite of the knowledge that Treasury would announce a 20 year TIP bond tomorrow. The auction is a week from tomorrow.

In addition, the bonds have rallied in the face of a collapse in energy prices as well as most other commodities today. Some investors believe that a slowing economy will sap the vitality from commodities and begin an extended period in which the recent gains consolidate. The price action in the TIP market would suggest otherwise.