What started as profit taking in the overnight hours led to an exodus of bargain buyers which exacerbated weakness and eventually evolved into all out liquidation. It was a brutal day for production MBS coupons and the Treasury notes that dictate our directionality.

5 year Treasury note yields rose 21.3bps. 7 year note yields moved 23.8bps higher. And 10s retraced another 20.6bps.  The resulting impact on "rate sheet influential" MBS prices was a 1-10/32 price decline for Fannie Mae 4.0s and a 31/32 dip for the new production coupon title belt holder, the FNCL 4.5.  Lenders were forced to reprice for the worse on multiple occasions. The best execution 30 year fixed mortgage rate has moved firmly up to 4.75%.

Blah.  This is that "snowball selling" we have referred to in the past, specifically on Black Wednesday in May of 2009. The correct terminology is "duration shedding" and we may not have seen the worst of it yet.  If 10s keep rising at this pace mortgage rates could touch 5.25% before the pain trade is fully played out.

Now. The question everybody wants answered...

Are we witnessing a shift in big picture investing perspective? Is the bond market building in an inflation premium? Is the economy recovering right under our nose? Perhaps.  Yes we are going to see an uptick in economic activity in 2011, but that will mainly be a factor of businesses investing in productivity enhancements via new technology...technology that will only widen the gap between what is already a large mismatch of the labor skills supplied by Americans and labor skills demanded by American companies. Yikes. I can't even go one sentence without bringing up what will soon be a lost generation of non-specialized blue collar workers.

My gut tells me what we're experiencing is a product of year-end window dressing, which favors chasing the equity rally to new highs (where profits will be booked) after a long run of stable profitability in the bond market. Of course it's hard to overlook inflation in emerging economies and ballooning budget decifits domestically as well as abroad, but I still can't get past structural weakness in our own labor and housing markets. Wait...does that mean the U.S. is turning into the next European Union? We're dealing with an unsustainable budget deficit and don't have a convincing enough debt reduction plan in place...and now the market is turning against the U.S.??? Is there now credit risk in U.S. debt? No way. Bernanke is already "printing" (not actually printing unless the money is created by banks via lending it out).

Ugh. I am trying to rationalize with you but it's useless.  I can paint a pretty picture for either camp.  I guess this explains why I've been so frustrated over my 2011 outlook. I'm swimming in contradictory data and events. There are too many compelling stories to be shared, all of which are pertinent to how interest rates might move in the future.....we just don't know what story the market will lean on as an excuse to grow profit margins.

I do know this though...

The bond market is behaving just like it did last December as we closed in on year-end. Remember when the 10 year note yield rose over 60bps between November and January?  After that we went sideways in a range for two months before headline risk (Greece) finally sent a flight to safety back into the bond market which led 10s back into their originator friendly trend channel. The time 10s spent outside that trend channel over the summer (into the fall) was motivated by QEII front running, which has clearly been wiped out heading into year end. 

Annnnnnd after today, we are once again outside (above) the originator friendly trend channel. Looks familiar...

Once again as we head into year end the economic environment has provided plenty of compelling talking points for us to use as an ax to argue either angle (bullish or bearish. wasn't it housing last year?ha), but year-end is not the time to be making a case for either camp. It is not a time to be reallocating strategic investments. Year end is a time to be squaring positions and cleaning out the pipeline. The resulting influence on the market: a lack of trading liquidity and increased potential for volatility. Day traders love it. Momentum is the most influential motivation. This happened last year and it's happening again right now.  If that's the case we won't be making much positive progress for the rest of this year.  We might see a few modest bounces but it's hard to believe we'll see a sustained recovery until the first few months 2011. But I do think we'll reenter the originator friendly trend channel in the chart above.....