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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.
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