Brian Reynolds on Treasuries
Whew! That was a "fun" week we had last week. Hopefully, everyone was able to catch their breath over the weekend, because the next few weeks promise to be very interesting.
When we recapped and interpreted Friday's action, the S&P was up at the top of its recent range, but unable to put in a new closing high, indicating that the correction may have longer to go in the short run. We have no idea whether the short run is a day or a few weeks; we had written that we thought it would take days for the 10-year Treasury to break below 3.93% if we got a soft payroll number, and it only took a minute. But, in the long run, we were getting some more stimulus on Friday from both Treasury buying (acting through mortgage refinancings) and from corporate bond buying (as those spreads only widened a little in the midst of the Treasury rally), and we are on the cusp of a lot more potential stimulus from refis should Treasury yields move just a little lower. As we've noted numerous times in the past, the only time when we've had both groups applying stimulus simultaneously in the last 5 years was last summer, which eventually led to significantly higher equity prices.
This move in Treasuries is starting to feel very much like the rally that occurred last May. There are a few different wrinkles, though, that are worth noting. The first is that there is a chance that mortgage investors may not suffer as much from having to buy Treasuries in a rising market to hedge themselves as they did last year. That is because, as we noted on Friday, that the rapidity of Friday's drop in bond yields brought in asset allocators who were selling Treasuries to buy stocks. That may have allowed mortgage investors to buy a significant amount of Treasuries Friday afternoon without further price damage. A look at the intra-day action of the swap market (USSP10 on Bloomberg), which is the first cousin of the Treasury market and an alternative vehicle for mortgage hedging, indicates that may be the case. If we were still running a mortgage portfolio (which is something we did in a former life), we would have been buying every Treasury-like product we could have in case other mortgage investors caused this move to feed on itself.
While there is a chance that mortgage investors may have bought enough Treasuries to hedge themselves, our experience is that there is always someone who didn't get the word that the boat is leaving the dock. They then plunge into the water in an attempt to catch up, and their ripples can have a big impact. So, it is likely that someone didn't hear "Last ferry for Hoboken, now boarding!" last week and finds themselves not hedged as much as they should be. That means we'll need to keep an eye to see how Treasuries behave in the weeks ahead when the asset allocation buying subsides to see if mortgage related buying of Treasuries takes over.
Another wrinkle is that this rally is more fundamentally based. We noted in the days leading up to the payroll number that sentiment toward bonds, especially in the Fed Funds futures markets, was very negative, and the payroll number was a big disappointment (we were quoted on this in this morning's Tracking the Numbers column on Page C3 of the Wall St. Journal. This is in contrast to last year, when investors were expecting a Fed ease, and silly rumors of the Fed buying Treasuries prompted strong buying by buyers other than traditional fixed income managers.
[That is the key paragraph - sentiment towards bonds is hideous and likely wrong - Mish]
The fundamental reason for the move in Treasury buying, in our opinion, gives it more strength. It also raises the possibility that, if we get more weak economic numbers this month, that those rumors of Fed buying will resurface, even though we feel we are far from the point where the Fed would consider that.
The other thing to note is the relatively good performance of corporates on Friday. That afternoon, we wrote that investment-grade issues looked as if they had widened 2-4 basis points, though trading was thin. We thought that would have been a good performance, because corporates are less liquid than Treasuries and thus normally lag them on big days. On a rally day like that, investment-grade spreads would normally be expected to widen 5-10 basis points.
However, corporates did even better than we thought. Investment-grade spreads only rose 1-2 basis points, and junk only 10 (it would have been expected to rise 15-20 on a day like Friday), only reversing the tightening they had put in during the week as Treasury yields rose into the payroll number. So, corporate yields were down on Friday, and if spreads can hold in here, or even recover, then that would be a big positive for equity prices. |
