MBS CLOSE: Markets FINALLY Hinting At The Future?

by Matthew Graham

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The FN 4.0 closed -0-17 at 98-04+ yielding 4.19% and the FN 4.5 closed -0-09+ at 100-28 yielding 4.397%. The secondary market current coupon is 4.313%.

Another Day of losses...  All the good times are over!  Right? 

Not so fast...  When we grasp for solace during such periods of chopatility, it must be time again for the type of perspective that can only come from another round of Market Psychology Play-By-Play.  We'll even throw in more visual aids to sweeten the deal!

So you're probably aware that at some time in the recent past, rates were doing much better than they are today.  Let's stab in the dark and call it October 7^th when MBS closed at 101-29, a more remarkable feat not seen since the 101-31 close on May 20^th, 2009.  Not only do we have the wide historical gap, but it isn't exactly like prices have been anywhere close.  Quite the opposite in fact:

By June 10^th, prices had fallen to an "abandon-all-hope" level of 96-21.  The degradation of the broader measurements of the MBS market wasn't quite so stark considering that being over 3 points shy of par tends to introduce some convexity-related distortion (lower an MBS yield is, the less likely investors are to ever get paid off at par, thus exponentially increasing the certainty that they'll lose money.  As those fears increase, investors flee the lower coupons with increasing speed, aka UIC or "up-in-coupon" momentum ensues.

All that to say: recent multi-month highs actually illustrate the meaningful dichotomy of summer months versus recent weeks.  Yes, MBS have done quite well for themselves into the fall...  But everyone is fond of reminding everyone else that Uncle Ben and the Gang are bowing out of the MBS purchase program soon.  Unwavering support for the more fear-inducing lower coupons is thus expected to be painfully absent.  And the relief pitcher is not expected to throw nearly the same amount of heat.  The safe assumption, currently being made by many an analyst, economist, and trader, is that MBS spreads to benchmark tsy's MUST necessarily widen at some point.  And if tsy yields are the same or higher, mortgage rates will be higher as well.

But even as stocks have risen (normally not coincident with rising bond prices), so too have MBS and Tsy prices, not to mention the improvement of spread between their yields.  It seemed that we were witnessing a game of chicken in which both competitors maintained their course, refusing to "stand-down" and allow victory for the other side.  Indeed, there is STILL too much uncertainty to say that one will definitively outperform the other.  Case in point: look no further than AQ's coverage of FOMC minutes?

So much waiting...  So much "back and forth" only to find our hearts, pulses, and lock sheets resting squarely on top of the proverbial fence day after day, week after week...  Such an environment is highly conducive to anticipation and heightened sensitivity to ostensible hints of direction.  And so it is on day's like 10/7, we find ourselves fearing the worst for bonds.  But then POOF!  100-28 magically appears on the horizon, allowing us to close precisely on the very highest closing price of the previous 4 months.  One man's ceiling is another man's floor they say...   And while that calms us in the short term, and though we are even able to rally off that low, days like today crop up without so much warning as a 1300 word prophecy...  That was yesterday's closing commentary, and here's how the last two days look at the close:

The ever present question: what now?  Sadly, just as I was loathe to call attention to the many anxious fences of the past four months, today is no better.  In fact, it's a classic example.  And though this doesn't necessarily answer the question, when charts like the following 10yr Tsy futures are read in conjunction with the kind of macro synthesis in yesterday's close, we can at least walk the existential path to MBS enlightenment in saying: "we are where we are."

Well, look at that crazy thing...  Let's rapidly dissect the hieroglyphics and let you get on with your evening.  Numbers and bullet points are almost certainly in order:

1.      Bonds approach psychological, technical, and actual highs at 118-00.  Successful breakout of closing prices on decent volume invites the investing masses to approve or deny admission into the 118+ club.  Result: APPLICATION DENIED!  "Not yet my fine friend...  We, the market, deem anything over 118 to be too high for you!  Oh, and don't go trying to test the water on an upcoming Friday or something because even if you make it back over 118, not only won't we let you stay there at closing time, but we'll smack you right back down into the 116's for a week or two!

2.      Bonds get several consecutive up days and are feeling lucky on the 28^th.  Back up through 118-00, but on low volume.  So nothing conclusive that day, and everyone waits for the verdics the next day.  Result: APPLICATION APPROVED!  "Yeah, you did your time in the minor leagues...  Welcome to 118 country!  In fact, we're going to start you off with the range of 118-05 since it seems like that was kind of a tricky spot for you over the past two weeks.  Good luck!"  But muttering under the breath can be heard: "Ha!  Stupid Bonds...  Little do they know that they'll get smacked right back down in earnings season or with the onset of fresh dollar weakness and inflation concerns..."

3.      But bonds didn't hear that...  They were too preoccupied with the slew of economic data and the "Bernanke Buzz" that came on Thursday.  They used the opportunity to make an application to the 119 club!  Who needs to wait around for 118's when uncertainty persists, inflation is not a threat, consumers are absent, and the recovery might be "U" shaped!  For a time, 119's are actually doable.  The psychological resistance even gives the old bond a few nice bounces to remain at multi-month highs.

4.      But all good things come to an end...  The "yeah buts" that were previously muttered under the breath of the 118 crowd turned out to be prophetic.  In not so much as two days, bonds were pulled right back down to the grounded reality of 118-00 EVEN.  In asserting their claim to greatness, they pushed back toward their more enjoyable 119-00, bet even INTRADAY trading firmly suggested the door was locked shut, EXACTLY on the 119 threshold.  No way to go but down, right?  Right...  But where to stop?   And the psychology finally arrives in the last yellow circle...  What more fitting ledge on which to come to rest than the most recent proving grounds supported by 118-05, 100% exactly to the 1/32 at the close of trading today...

At least we can infer one thing about the future with certainty: We're once again SQUARELY ON A FENCE AND WILL COME DOWN ON ONE SIDE OR ANOTHER. 

MBS, Tsy, and LIBOR Quotes