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Analyzing the QE Meltdown, Ex-Ante


Correlation does not imply causation.


The FOMC release hit the tape and announced that QE III was forthcoming in the form of increased MBS purchases, but that wasn't nearly as important as the following statement:
If the outlook for the labor market does not improve substantially, the Committee will continue its purchases of agency mortgage-backed securities, undertake additional asset purchases, and employ its other policy tools as appropriate until such improvement is achieved in a context of price stability.
This was a very dovish development and meant QE was now open-ended, and not predicated on a time frame but on an economic outcome. Just as we suspected last week, it was essentially an implicit targeting of the output gap. The bond contract immediately collapsed and sliced right through the 146-16 pivot, but quickly bounced back and stabilized with only minimal damage. Still, while mortgages screamed higher, the reaction out of Treasuries was clearly focused on the inflationary implications.

The market had absorbed a lot of supply and a surprising launch of QE III so you would have expected Friday to be a slow day. The overnight session, however, proved to be a different story. The curve steepening had continued and the bond contract was gapping lower through our 146-16 lower pivot and had traded as low as 145-16 just before pit trading opened.

One thing that was not on the agenda at Thursday's FOMC meeting was NFL football, but it probably should have been. On Thursday night, the Bears played the Packers and the traders in the pit were no doubt out late, hung-over and in a bad mood when they came in Friday to find stops triggered and bonds gapping lower. I can assure you this has an impact on market liquidity.

I don't know this for sure, but my guess is that the locals were not there to step up and take down a wave of sell orders. They probably were out to get in front of the selling not to take the other side. The bond contract opened down almost 3 points from Thursday's close to 144-16, and after a brief oversold bounce to 145-16, rolled back over to finally settle just under 145-00. Nevertheless, severe technical damage had been done with both prices and yield closing out the week at levels not seen since mid-May.

Bloomberg reported after the close:

Treasury 30-year bond yields (^TYX) climbed the most in three years after Federal Reserve Chairman Ben Bernanke's pledge to keep adding stimulus even as the economy improves spurred concern inflation will accelerate

The yield gap between 10- and 30-year Treasuries widened to the most in a year yesterday amid bets the value of longer-term fixed-income holdings will erode more over time.

Yields on 30-year bonds increased 26 basis points, or 0.26 percentage point, this week in New York, according to Bloomberg Bond Trader prices. It was the biggest jump since August 2009. Yields touched 3.11 percent, the highest level since May 4. The price of the 2.75 percent security due in August 2042 slumped 5 2/32, or $50.63 per $1,000 face amount, to 93 13/32.

The 5YR/30YR spread we cited last week had gapped out and had virtually wiped out all the flattening that had occurred from Operation Twist. The bond contract closed 1.5 points below the second lower pivot we cited on Monday and the 30YR yield appears to have broken the down trendline that has been resistance since last year when yields were over 4.00%.

When QE II was announced in 2010, the curve violently steepened. The 5YR/30YR spread widened 90bps between the widest points of both August and the November with the 30YR yield rising from 3.50% to 4.75% in February 2011. Here's where it gets even trickier: That was with much higher coupons. The August 2010 30YR coupon was 3.75%, but this 30YR coupon is 2.75%.

As you know, for a given duration, the lower the coupon the more sensitive price is to a move in interest rates. The 3.75% 30YR coupon has a duration of 16.7 while the 2.75% 30YR coupon has a duration of 19.1, meaning that the 2.75% is much more sensitive to a move in interest rates. This was a fact not lost on the market last week where the extended duration can be attributable to over 10% of the total move.

This may not sound like a material amount but when you amplify this throughout the entire bond market and include the negative convexity in MBS and Agency debt you have the recipe for quite a toxic environment if this market is ready to turn.
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