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What's Driving Intense Volatility in the Bond Market? Three Possible Explanations


Forget Dow 14,000. What's happening in the bond market is significantly more important.

Equity investors went home this past weekend feeling pretty proud of themselves. For many who recently (and finally) gained net exposure to the market and after a blistering January, stocks started February with a robust 1% gain. The sentiment has improved not because economic conditions are better but rather because prices are higher.

Last week we saw the first estimate of Q4 2012 GDP and it was a stinker. The number that matters, YOY nominal GDP, grew at a paltry 3.3%. This was one of the lowest prints since coming out of the recession and a sharp deceleration from Q4 2011 at 4.0% and Q4 2010 at 4.3%. Even in Q4 2007 as the wheels were coming off, the growth rate was 4.9%.

In dollar terms Q4 2012 nominal GDP came in at $15.829 trillion, only $500 billion above last year. Pundits and strategists were quick to explain away the weakness with a sharp drop in defense spending which I guess is notable. However that doesn't alleviate the ballooning debt/GDP ratio, now at 104%, nor does it help the ever elusive output gap.

The non-farm payroll data was also weaker than expected, coming in at 157k v. the estimate of 175k. The numbers that matter were also weak with private payrolls adding 166k v. the 185k estimate, and manufacturers only added 4k. As a comparison, last month private payrolls were up a revised 202k with manufacturing at 8k. In January 2012 private payrolls added 323k with manufacturers adding 44k.

The ISM manufacturing number was the highlight of the day, coming in at 53.1 versus the estimate of 50.7. Perhaps manufacturers were upbeat because they didn't have to hire anyone. The January number tends to run hot, but 2013 was still weaker than 2012's ISM at 53.7, 2011's at 59.2, and 2010's at 58.2.

I put these numbers in historic context because as you will recall, sentiment was much more bearish on the prospects for the economy and equity prices back then with stronger data. Only now, with the indices at new highs, is data justified to warrant the recent parabolic price action.

While all the headlines and attention is going to the equity market, it was the bond market that saw the real action last week as the 143-00 objective I have been monitoring was finally tested. This is significantly more important than Dow (INDEXDJX:.DJI) 14,000.

On December 28, 2012 I wrote the following in A 2008 Bond Market Prognostication:
If the Fed is successful in reflating the economy in 2013, the Pyrrhic victory could be a real scenario and if it gets traction the market could be under significant pressure and the lower objectives would be in play. Because of the technical nature of the rising channel and important 143-00 level I think on balance there is less margin for error and thus more risk on the downside.

The bond market has been consolidating a relatively tight range for six months and has lulled many participants to sleep. I think this thing is wound up and ready to break out. It's unlikely that we will be sitting in this same spot next year; which way we go and where we end up is going to have wide-ranging ramifications for the asset markets and implications for the economy.
Last week I wrote the following in The Great Rotation? The Market Is a Bit More Complicated Than That:
If the market needs to test 143-00, next week could be a great opportunity. You can see on the chart there is enormous support in the area between 143-00 and the rising channel. The fate of the bull market will bet settled at these crossroads. Expect this area to get vibrated and the reflexivity of the MBS market to play a key role in how this gets reconciled.

US Bond Futures Five-Day Tick

Click to enlarge

You can see that out of the gate on Monday volatility continued and the pressure was on the downside. On Wednesday bonds took out 143-00 and in an intense session that saw huge volume of 615k contracts turning over the entire open interest in a relatively tight one-point range. The 10-year (TY) futures contract traded 1.86mm contracts and settled basically unchanged. It was a wild day and I commented on Twitter that when you see that kind of volume turn over in an unchanged market, that typically is a sign of a bottoming process as the supply has been adequately absorbed.

However as you could see on Friday (February 1), Wednesday's price action was only a sign of more volatility to come. After successfully testing 143-00 on Thursday, bonds were right back there on Friday before the NFP release. With the weaker NFP print bonds caught an immediate bid and rocketed back to the highest levels on the week and it looked like 143-00 was going to be made support. The bid quickly faded though. And when ISM beat expectations, the bottom fell out, taking out 143-00 like warm butter and eventually closing at the lowest level on the week in another wild session.

This time both US and TY turned over the open interest with bonds trading 693k contracts and tens trading 2.2 million which together equates to nearly $290 billion notional traded on the day. When it was all said and done the week saw the highest volume traded in notes and bonds since the massive flight to quality in the August 2011 stock market crash.

I knew 143-00 would be a critical level but I didn't expect this kind of intense volatility. What was behind this record level of volume? This was not economic data related, stocks breaking out, or the great rotation nonsense. This was big money whipping around.

There are a few possible explanations as to what is causing this bond market intensity and today I want to go through three ideas -- one new thought that could be having an influence, and two that I have discussed over the past few weeks which seem to be gaining momentum. They are all probably contributing in some form or fashion and the key issue going forward is whether they will continue to put pressure on bond prices.

On Thursday I was rapping with Minyanville's own Michael Sedacca about why the Fed's QE US Treasury open market purchase bid to cover ratio has been tracking higher. The bid/cover shows how many bonds were offered in the tender versus how may the Fed bought.

SOMA Bid to Cover Vs. 10-Year

Click to enlarge

You can see that clearly that the ratio of bonds offered to the Fed has been rising since the beginning of the year, and this excess supply is correlated with the rising yield on the 10-year. Sedacca and I were trying to figure out what was driving this supply.

I said one possible explanation is the expiration of TAG (Temporary Liquidity Guarantee). TAG insures non-interest-bearing deposits in banks for unlimited amounts and was implemented during the credit crisis so that large cash deposits for corporations used for things such as payroll wouldn't flee for fear of bank failures. Presumably when TAG expired at the end of the year those deposits would seek other government-guaranteed short term liquid assets outside bank deposits. Why would that affect the long end of the curve?

Banks invested some of these deposits in liquid Treasury, Agency, and MBS duration to earn a spread or carry. According to the Fed's H.8 weekly report on bank assets and liabilities, during the last six months of 2012 deposits trended higher rising by over $400 billion while holdings of Treasury and Agency securities rose by $100 billion maintaining the recent trend of investing roughly 25% of deposits in securities. Between December 26, 2012 and January 16, 2013, non-time deposits deviated from the general rising trend falling by $88.4 billion, and over the same time their holdings in these securities fell by $20 billion, which is 23% of the reduction in deposits.

According to ICI, in the same four-week period institutional money market funds have increased by $22 billion, which also explains the above-average buying by direct bidders at recent two-year and three-year Treasury auctions. Corporate treasurers aren't investing liquidity in the stock market so presumably the expiration of TAG can explain some of the selling in the longer duration assets and purchasing of shorter more liquid securities. The great rotation might just be out of cash deposits and into two-year notes. The curve steepening in as yields rise also corroborates this assertion as the two-year/10-year spread has widened 25bps year to date.

As I noted last week, the reflexivity of MBS convexity selling could also explain some of the bond market volume and volatility. As I have mentioned before, due to negative convexity MBS investors hedge their duration risk with Treasuries, buying duration when yields fall and selling duration as yields rise which in extreme markets can exacerbate the move. The 2.00% level on the 10-year is a key psychological level but is also represents a significant pivot point for MBS investors.

Last week BAML strategist Satish Mansukhani wrote in client note that 10-year yield rising to 2.15% will increase convexity risk while further 10bps-25bps rise would generate "significantly higher" hedging needs. To give you an idea of the magnitude of the extension risk, the analyst noted that the previous week's move extended outstanding agency MBS duration by $177 billion 10-year equivalents. This interplay between MBS and Treasury hedging of extension risk was evident during last week's volatility but seemed to subside a bit on Friday as MBS outperformed on the day.

The third market element that is behind this intense volatility in the bond market is the continued weakening of the Japanese yen amid further dovish rhetoric. On Friday you may recall S&P (INDEXSP:.INX) futures were already bid up six points before the employment data was released. This was perhaps on the back of comments made by BOJ Deputy Governor Yamaguchi who said that the central bank was making a stronger pledge this time that previously.

According to Bloomberg:
Yamaguchi said in his speech that the BOJ will pursue "aggressive monetary easing" as long as it deems appropriate, adding that the bank's price target is the same as the "flexible inflation targeting" adopted by many central banks.
The EURJPY rally has no doubt been a green light for risk at the expense of US interest rates and Friday was no exception. When the ISM number hit EURJPY rallied nearly 1.5% in an hour. Year to date the EURJPY is up 11% while the THBJPY is up 10%, both outpacing the S&P 500 which is up 6.1% and high beta Russell 2000 (INDEXRUSSELL:RUT), up 7.3%. Currencies shouldn't be moving like stock indices, and when they do, the reverberations can be felt in credit markets. We first pointed to the correlation between the JPY and US interest rates and the risk of the BOJ's new inflation target in Is US Growth Blowing Out or the Carry Trade Blowing Up? The further JPY weakens the more US interest rates could rise.

US Bond Futures Weekly:

Click to enlarge

As you will recall, since the end of 2012 I have been working off the thesis that the biggest risk in the markets is that they lose confidence that the Fed can control interest rates in the long end of the curve, and the critical 143-00 pivot was an area where this thesis could play out. Last week was a frightening testament that when this market is ready to move there is little the Fed can do about it. At this point either this level holds and bond prices continue to rally back to old highs or it gives and the QE trade unravels in their face. If bonds are topping, what kind of world would that look like? Despite the current optimism about stock prices that's a question you don't want answered.

Twitter: @exantefactor
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