Just like sometimes we see profit taking after a nice rally, sometimes we see profit taking after a sell off.

We're talking about short sellers. These traders are looking for interest rates to rise. When rates do rise and trader's think they might stop rising, that short position is "covered". This effectively books a profit on a bearish tactical trading bias. Short covering has been a sizable component of the benchmark TSY price gains we've seen since Tuesday. This short covering has also helped FNCL 4.5's bounce higher since touching 100-00 on Tuesday. REMEMBER PARNERTIA? 

Short covering rallies aren't our favorite because they don't necessarily speak to organic strength in bonds. But they do provide a hint of positivity. Short covering implies traders are nervous about their bearish positions. Short covering into sell-offs implies bearish traders are defensive of their profits. They are nervous rates won't move any higher.

There's been more the rally than short covering though. Geopolitical undercurrents are also exerting their effects on markets. 

The GSE White Paper and prior to that, the leak of its details, did a fair job of widening out MBS spreads over the past week. Current coupon yield spreads did tightened up today once the White Paper was absorbed on the street. Earlier cheapening wasn't unwelcome though. Valuations were still relatively rich leading up to Class A roll on Tuesday afternoon. Egypt was a source of strength early in the session today. Unfortunately Treasuries did lose some of their "flight to safety" luster after Mubarik officially resigned from the Presidency. 

Those two things, short covering and a headline driven flight to safety, aren't the best two places to look for recovery rally motivation. If that's all we have, then we're still clearly very much in the post-range-breakout doldrums. Snowball selling is still a risk.

There are other reasons to believe the bond market might regain its fundamental footing though. We had two updates on inflationary expectations this morning. The Consumer Sentiment Report and the Philly Fed's Survey of Professional Forecasters both indicated NO CHANGE in core inflation expectations. Rising commodity prices are however expected to drive food and energy costs higher. Chairman Bernanke told us the culprit of that inflation is overheated demand from emerging economies. Not monetary policy. As we've preached many times in the past, cost push inflation without a corresponding rise in wages only tightens margins on Main Street and forces more saving. Not good for spending!

FNCL 4.5's finished the day just a few ticks below session highs and right in the middle of the recent range. MBS outperformed TSYs into the rally as well (see comments above on yield spreads)

More simply put, treasuries were already closer to their best levels of the week coming into today.  At 100-07, FNCL 4.5's were near their worst. Chalk that up to the spread widening brought on by the one-two punch of a GSE white paper and the potential for snowball selling

The weekly action gives MBS a nice horizontal range between par and 101-00 to work with, with something of a pivot point right near the midpoint. 

But for benchmarks like the 10yr note, the situation is a bit more ominous.  Yields are getting crowded by a trendline converging down on the 3.63 zone.  So yields either have to move lower than that, or are forced to break through that supportive trend-line.  And we think with 3.57 on the low end as the most significant resistance and with 3.85 on the high end with the most significant support, this is a bond market currently, that needs more motivation than it currently has to test for re-entry into the previous range just yet. 

A big old stock market sell-off would probably do the trick.

Could it happen next week?  Sure, it could certainly happen if we shoot the moon with respect to suportive data and a stock market sell off.

It would take Retail Sales being tepid or worse, CPI being unchanged or lower, PPI being unchanged or lower, Jobless Claims retracing this week's positive progress, and a cooperative reading of the FOMC minutes on Wednesday.  Or maybe just one fat finger flash crash event on the floor of the CME. It could just as easily go the other way though and 10s could be sitting at 3.85% in a matter of days which lead to snowball selling and "Best Execution" mortgages priced at 5.375%