At the 9:30am US Stock Market open, S&P's shot about 10 pts higher in mere minutes. Combined with ongoing weakness in German Bunds, that dragged Treasury yields higher and MBS to their lows of the morning. Even so, it looks like 10yr yields are making their first attempt at a 1.95% bounce, in line with Wednesday's high yields, and MBS looking back a bit further to 101-18 support from the morning of the 21st. Fannie 3.5's are already back up to 101-22, but illiquidity can result in choppy moves in either direction. Given the low volume, futures rollovers, and limited market guidance, we'd remain hesitant to read much into today's trading levels. That said, the weakness can and will have an effect on lender pricing this morning.

(Reuters) - Wednesday's failed bond auction in Germany may mark the moment the penny dropped for Berlin. That, at least, is the hope of some of its European partners.

While Greece, Ireland and Portugal have had to suffer the ignominy of taking bailouts from the EU and IMF, and Spain, Italy and France are now firmly in the firing line, Europe's most powerful economy has remained above the fray.

But the inability to sell nearly 40 percent of the bonds offered at an auction of 10-year Bunds has suddenly revealed a *** in Germany's armor, with implications not just for the markets, but for the politics of Europe's debt crisis too.

At one level the auction was not so bad -- no other euro zone country can sell 10-year debt at a yield below 2 percent in the current environment, and if a few more basis points had been offered the 6 billion euros of bonds would have sold without a hitch -- but at other levels, deep problems lurk.

The very image of German debt management superiority has been called into question, and by extension so have some of the more rigid positions that German Chancellor Angela Merkel has adopted over the course of the debt unrest.

Other euro zone states -- most particularly France -- will now feel emboldened in challenging Germany's resistance to ideas such as the European Central Bank playing a more direct role in firefighting the crisis and to jointly issued euro zone bonds.

French President Nicolas Sarkozy met Merkel and newly appointed Italian Prime Minister Mario Monti in the French city of Strasbourg on Thursday, with the ECB's role at the heart of discussions.

Although US Treasuries have been trading in generally weaker territory since 8pm last night, and although the day-over-day change shows 10yr yields just over 3bps higher, they're actually STRONGER this morning. How can that be?

Fairly often, you'll see us mention MBS being a "spread product" trading versus benchmarks like Treasuries, but the latter also has spread considerations versus other sovereign debt, namely EU Benchmarks, aka German Bunds. When US 10yr Treasuries were around 2.06% on 11/10/11, German Bunds hit 1.686%. Advantage: EU... But after the Bund auction earlier this week garnered only 2/3rds of the bids needed to cover the auction, they've been in a death spiral, now trading at 2.245 vs US 10yr's at 1.92. Keep in mind that these two securities share an extremely high degree of positive correlation--more than Treasuries and MBS, or Treasury yields and stock prices by far. Over a 2 trading session period, this is the most the spread between the two has ever moved. The fact that US Treasuries are still in the low 1.9's is a positive indicator for the US Bond market.

Elsewhere in the US bond market, the securities with which we are more keenly interested are slightly weaker as well, but with similar themes playing out. Case in point, like Treasuries, Production MBS are lower this morning, but also like Treasuries, they remain contained by 11/23 lows. Fannie 3.5's are currently 5 ticks off Wednesday's 5pm levels at 101-26. This level seems like it was a baseline for a lot of rate sheets on Wednesday, so pricing may not be a whole lot worse today, despite the red (provided that we don't leak any lower before sheets start coming out).

There's no economic data on tap today and volumes are extremely light. Volatility is possible, but as we said 2 days ago, we wouldn't read much into trading levels until next week.