The last 6 months have been remarkably easy to understand compared to now.  At least during that time, we could rely on the market's relative certainty of weakness.  But now enter the "uncertainty," not to mention the uncertainty surrounding how we've dealt with it as most recently manifested by the AAA credit buzz.  Uncertainty carries a hefty price and you're seeing it on rate sheets and in debt prices.  Combatting certainty of something is a much easier proposition than combatting the uncertainty of something.  In other words, weakness was certain, so the Fed spending money alleviated the situation.  At each turn, the market's certainty of weakness would shift for the worse, the Fed would spend more, and things would improve for debt markets.  That worked fabulously as long as markets were certain of the location of the problem.

But as of yesterday, and perhaps gradually before then, the certainty of "where is the problem here" began to wane.  Though it's been brought up before, the past two days are the first tangible example of what happens when "that which combats certain weakness" is itself, called into question.  If the only way we've been effectively able to fight fires is by dousing them with water, what do we do when the perception takes hold that the water is actually creating more damage than the fire itself?  Let the fires burn?  Reassure people about the water?  Find a different way to fight fires? 

Such is the plight of the Fed and indeed of the entire nation.  When there was no doubt as to the propriety of their response, their involvement has only been a net positive for debt markets.  Fed's gonna buy MBS?  Great!  Fed's gonna buy treasuries?  Great!  But now: "Is the Fed buying too much?" is a thought that is so important right now that--in a different iteration--it even made it into the most recent fed minutes as several governors expressed concern that the Fed's balance sheet is growing too rapidly.  Do I think it is?  No...  But I don't matter.  If enough of the market thinks it is, or more broadly, if enough of the market thinks we're using too much water to put out these fires, it won't be a happy time for debt markets in the near future.

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The cause for this week's weakness...

The first story of weakness for MBS this week was that of treasury supply concerns.  In and of itself, it likely would not have left us where we close today as it has been a familiar dance for treasuries to sell off before auction weeks.  But now enter Bill Gross yesterday discussing a potential cut to our country's credit rating and the selling cycle might have longer legs.  The first warning of that was another hefty day of selling today, and NOT with the light volume that was expected.  In fact, MBS fannie 30yr fixed volume was about 10% higher than it's 30 day average!  How much of that corresponds to yield curve position-taking for the long run or simply some over-hedge for a long weekend with some hefty auctions on the horizon is uncertain.  One thing is certain: it used to be that the Fed could just wave it's magic wand and say "More Open Market Operations!" (aka Fed Buying) in treasuries, and yields would drop.  But NOW!  Now, my friends, those hands are much more tied as they are implicated in the weakness themselves.  (Not the Fed per se.  Only inasmuch as they are one of the key entities pumping money into the system, and the "pumping of money into the system" is a main cause for credit rating concerns, and credit rating concerns were a main cause for debt market selloff's this week).  Basically, a catch 22.

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What do we do now?

From a technical perspective, today was not so good.  In the sense that there was indeed high volume, that's an argument in favor of counting today in our technical analysis as opposed to previous plan: throw it out.  On the other hand it STILL is a short trading day ahead of a 3 day weekend which traditionally sees a lot of over-hedge.  Certainly we'll give it to Tuesday from a long term perspective.  But don't expect any price improvements Tuesday morning unless we get a friendly tape bomb over the weekend.  This would basically require the Fed to come up with a new way to fight the previously analogized fire, and introduce it over the weekend.  Probably not going to happen, but one never knows.  So once you make it to Tuesday with no rate improvements, you'll immediately be at the mercy of the first $40 bln of over $100 bln of treasury auctions next week.  Be advised, these will set the tone for the week from a scheduled data standpoint (always leave room for unexpected headlines).  A reasonable amount of weakness has already been priced into tsy's going into this auction, but I assure you, it's nowhere near the amount of weakness we'll see should the auction results confirm creditworthiness fears.  A horrible auction on Tuesday and no immediate and extremely creative response by the Fed and/or our government could well usher in a sizeable chunk of "unhappy time" for both MBS and Tsy's. 

Of course, MBS have been staying much preferred to Tsy's when sellers have the reigns.  Today is no exception as the 10 yr is down 19 ticks, but the 4% coupon only down 4 ticks.  There is a bit more room to run here too, in terms of spreads.  But we've now surpassed the September/October lows in spreads and are back to 12 month tights as one can see in this chart:

The tighter we go, the closer we are to inevitable resistance.  And REMEBER!  If the AAA credit rating of the US is being called into question, that is an indirect attack on MBS as well since so much of this spread tightening is due our government spending money in MBS, something they won't be able to do so cheaply with a lower credit rating.

For an idea of how quickly things could get bad, take a look at the last 6 months.  We're still pretty close to the middle of that range with all of February and half of March averaging much lower prices.  So it's very much NOT out of the question for some caution ahead. 

So since we began with the them of uncertainty, we end there as well.  SO MUCH rests on next week's auctions and any potential response from the Fed et. al. concerning the credit rating debate.  For the reasons AQ already outlined, there are plenty of reasons for rates to rally assuming things don't get catastrophically bad in debt markets next week.  But for the first time in what seems like a long time, there is a real risk, even if it is still small, of things getting catastrophically bad.  Plan accordingly.