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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.

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.
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