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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.

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
No positions in stocks mentioned.
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