Lot's Going On Tomorrow:
- MBA purchase applications at 7am
- ADP Employment at 815
- Treasury Refunding Announcement at 900am as well as the 30yr bond announcement specifically
- ISM Non-MFG Index at 10AM
- 3's and 10's announcement at 11AM
- FOMC announcement at 215pm
It might not look like nearly as important of a day tomorrow as it actually is... Of course we've been talking about the FOMC announcement and I think its significance is largely understood. But it has some nuances and some interconnection with today's losses as well as the refunding announcement tomorrow that add complexity, uncertainty and potential for movement. Fill in the rest of the day with the increasingly "looked at" ADP report and the veritable cornerstone of tier 2 econ data, ISM Non-MFG, and you have yourself quite the day. All this in addition to the fact that the hits are anything but metronomically timed..
In other words, there's some early econ data, then some early bond data which paints important but not all-encompassing parts of thre refunding picture. Then you wait an hour and get a moderately important tier 2 econ piece with the ISM, and one hour later follows round 2 of refunding data with 3's and 10's which you'd THINK would paint the rest of the refunding picture, but nothing is anything until the Fed unveils the canvas on which said picture will be painted. And for that, we wait a gruelling 3 hrs+, almost as if to invite rampant volatility and speculation. But there are two schools of thought on whether the Fed or the Refunding is the soup of the day.
According to one side of the argument, those 3 hours really won't be so gruelling because it's an almost universally accepted fact at this point that there will no change to the Fed's language regarding "extended period of time." They're largely justified, especially as far as that particular verbiage is concerned. In fact, a report out today indicated that a majority of the board is NOT interested in changing the verbiage. Thus, this school suggests that today's weakness is more of an "UNWINDING of FOMC VERBIAGE CHANGE FEARS." What exactly does that mean?
PLAIN AND SIMPLE:
24 step program for anyone who is lost when we talk about the yield curve (or who just wants to fill in some holes).
No question that these economic bulls get right back up when knocked down... So the bears are gradually having to actually speak the phrase "rate hike" no matter how euphorically long the historically low rates will last. In other words, the economy is showing signs of recovery that everyone must recognize as "something." And regardless of what they think that means for the future, they have to entertain the possibility that it could lead to a shift in Fed policy or even rates, and also to discuss what those changes might look like and when they might arrive.
So the stock market and econ data has evaded outright catastrophe even as the pace of indicator improvements has slowed, so why not start the buzz about rate hikes and verbiage changes now right? Those behind such thoughts soon agreed that an outright RATE HIKE was out of the question for this November meeting, but the debate turned to the potential verbiage change from "extended period of time" to something else as far as hinting at how long before a rate hike. Event this debate has largely died down and finally been put to rest with the aforementioned report on the majority siding with the status quo.
And believe it or not, the conclusion that the Fed would NOT introduce new verbiage into the mix played into weakness in the bond market today. That makes almost no sense right? Why would their decision to keep not only the rate but even ther verbiage unchanged possibly hurt today's rates?
Long story short, it's all about the SHAPE of the YIELD CURVE. For those that still tune out when we start talking about the yield curve, just remember a few basic principles and you should be fine:
- We're talking about yields on treasuries ranging from the very short durations to the very long.
- When a certain section of the yield curve is weak, it's prices fall and it's yields rise, pushing that section of the yield curve higher
- When prices rise, the yields drop, making that section of the curve lower.
- the 1-3 year "stuff" can behave quite differently from the 10-30 year stuff.
- Lets just call all the "stuff" in that shorter range near the 1-3 yr the "short end"
- and moving out toward the 30 year bond, how about "the long end"
- Right now at least, and historically much more often than not, the short end has LOWER YIELDS than the long end.
- So it's kind of like the PRICE IS RIGHT yodeler mountain moving up in altitude as one travels from left (short end) to right (long end)
- Rates in the long and short end don't necessarily move in the same direction by the same amount.
- It's these varying rates of change in the yields all across the curve that we're referencing when we discuss the SHAPE of the yield curve or STEEPENING or FLATTENING.
- If it wasn't clear before, maybe you're starting to see where those words might come into play
- if yields in the front end stay the same or go up at the same time long end yields go down, the SHAPE of the "Yodeler's Mountain" would get FLATTER.
- The mountain is the yield curve and the phenomenon is a "FLATTENER."
- Conversely if short duration yields are FALLING and longer duration yields are RISING, the overall yield curve would be getting STEEPER.
- Guess what that phenomenon is called? (hint: it's a "steepener).
- In the most basic sense, there are 2 dimensions in which the yield curve moves
- dimension 1: STEEPER Vs. FLATTER
- dimension 2: HIGHER vs. LOWER
- In other words, rates could be moving HIGHER overall at any given time, but if the short and long ends of the curve are changing at different paces, there will either be FLATTENING (in the case of short yields rising FASTER) or STEEPENING (in the case of long end yields rising FASTER).
- The "high and low" dimension is often referred to simply as BULL and BEAR.
- It's VERY IMPORTANT TO NOTE that "bull and bear" in this context refer to PRICE and NOT YIELD!!!!!!!!!!!!!!!!!!!
- Ipso facto, a generally BULLISH yield curve would mean RATES ARE FALLING. Bearish = rising.
- You can sound clever at your next cocktail party by discussing what rates did or are going to do in the context of the two dimensions above. If short term rates held steady and long term rates moved higher (worsened, backed-up, etc..), knowing that this makes the shape of the curve STEEPER and that the overall tsy market went DOWN IN PRICE on the day, you can say: "Did you catch the BEAR STEEPENER today?"
- So to recap, that's BEAR/BULL and STEEPENER/FLATTENER. Several combinations make for hours of fun for you and your office...
Yes, if you're still reading, we can finally come back to the original question... What's all this about "unwinding verbiage change fears?" In the interest of keeping it short from here on out, please forgive the cursory treatment, but if you want to come back to the discussion in greater detail, just post your request in the comments.
Basically, Fed policy has the most drastic impact on the short end of the yield curve. So short term rates would have the most to fear from a potential shift in verbiage, let alone a rate change. If such a verbiage or rate change was still on the table, short term rates would likely be "backing up" (moving higher) relative to the rest of the curve which wouldn't have as much to fear from such an event. In a nutshell, any easing in language or in the accomodative nature of policy would be assumed to create FLATTENING in the the yield curve.
The curve is quite steep historically, and in fact, when the "what's the fed gonna do" discussion was more hotly debated, the yield curve DID flatten with the gains we saw at the end of last week. FLATTENING is GENERALLY what we want to see as originators as it means that the longer duration portions of the yield curve that more closely mimic low rate MBS durations are, at the very least, moving more toward the rates in the short end. If it happens to be BULL FLATTENING, where rates are dropping AND the long end is dropping faster than the short end (standard issue rally actually... Bull steepening is less common), that's usually the best scenario for lower coupon MBS (aka "down in coupon")
So AS THE EXPECTATIONS FOR A SHIFT IN THE FED'S VERBIAGE FADED, THE RISKS TO THE SHORT END DIED DOWN AS WELL. THIS SCENARIO SUGGESTED MORE BULLISHNESS FOR THE SHORT END, AND THUS THE STEEPENER WAS THE LIKELY OUTCOME. If that last sentence made sense, move on. If not, well, print and re-read until it does, or give up and send us nasty emails about needing to hire a new writer...
In any event, the flatter vs. steeper dimension was seen by some to be accounted for by the UNWINDING of the Fed's verbiage change risk. It's complimented well by the refunding announcement tomorrow. We get 10's and 30's, two good representatives of the long end of the curve. With the speculation on the fed dying down and at the very least not precluding steepening (if not outright contributing to it), it's possible that the unknowns of the refunding and the other economic data tomorrow come back into greater focus. In other words, "the fed discussion is over, let's talk about refunding..."
If one moves on to the refunding topic, and then considers 10's and 30's as indicative of the long end, and ALSO considers the standard operating procedure of late has been to back yields up to technical extremes ahead of supply news and auctions, then you have yet another vote for the STEEPENING today (uncertain outlook on impending data that speaks to long end of curve causing the long end yields to worsen faster than short end yields). But so far, we've only accounted for TODAY (and we didn't even talk about the CA Bond auction that mysteriously coincided with some sharp price deteriorations). Thankfully, the rest is only one paragraph...
All of the above to say that some think the focus of tomorrow should be on the econ data and the refunding while others place more kinetic energy with the FOMC announcement. If you were in one camp more than the other, it might inform the times of day that you'd expect volatility and more importantly, your reactions to any ahead of the tape interpretations of the data offered by us or others (well, probably just us really, if you plan on doing anything about it before rate sheets change). Ahem.. Still... I'd caution anyone against ruling out either side of the equation. If anything, it seems at this point that the refunding is more of the known quantity than the FOMC. Regardless of verbiage or rate changes, the statement will be brutally dissected for hints at the future, with traders betting on the flavor of the minute almost the entire afternoon.
But I'd also agree that the Am data has almost as much potential to move the market. So be aware the volatility may get started quite early. We'll know more about how traders are approaching the relative weight of tomorrows events as positions and volume are seen tomorrow. If things are quiet or even if they're loud but retrace to the status quo before the FOMC, the latter gets the vote. Either way, get your rest tonight, tomorrow has more potential to be a wild one than many days in recent memory.
Here are the obligatory charts and data for those that wondered where the heck they were.
The FN 4.0 ended the day -0-05 at 95-05 yielding 4.19% and the FN 4.5 headed out the door trading -0-04 at 100-27 yielding 100-27 4.399%. The secondary market current coupon closed at 4.347%. +88/10yr TSY and +70/10yr swap. Yield spreads were essentially unchanged on the day as MBS coupons went in step with their benchmarks
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