Anytime I can use the word "strategery" I am a happy man....

Benchmark interest rates backed up yesterday in a low volume trading environment.  The move was short term in nature but clearly illustrates the idea that investors have already baked QEII into risk-free debt valuations and further QEII details are needed if yields are to move any lower (the right details = at least $500 billion + new iteration which extends the "rates low for extended period" period).

This behavior was not unexpected though.  On October 15 I described this price action as follows...

Energized, Exuberance, Over-Exuberance, Exhaustion, Uncertainty

Energized: Over Another Federal Reserve "Quantitative Easing" (QE) program

Exuberance: Think of "QE" as a strategy employed by the Federal Reserve to force the economy into a sustained recovery. This strategy might include large scale open market purchases of Treasury debt or MBS (Bernanke has indicated MBS purchases were possible). If that scenario played out, it would be very supportive of  mortgage rates touching 3.75% again.

Over-Exuberance:  Too many investors piled onto the same side of the bond market. When investors learned the Federal Reserve was seriously considering the idea of another QE program, they upped the ante by purchasing more government bonds, which pushed Treasury prices higher and higher and Treasury yields lower and lower. This is what led mortgage rates to new record lows.

Exhaustion: Mortgage rates touched new lows and bond prices touched local highs, but when the market came back from a long holiday weekend investors wanted more details on the next QE program. Without further details, the bond rally stalled and the trading environment turned stale. We had three ugly Treasury auctions and that was the straw that broke the camels back. Mortgage rates have not returned to new record lows since then....

Uncertainy:   Investors need to hear more details about the Fed's preferred QE strategy, specifically the tools they would utilize (including communication), the size of any asset purchases, and the timing of such purchases, unfortunately nothing of the sort has been offered.  That sentiment combined with the "pain trade" (see over-exuberance comments above) has led benchmark Treasury yields higher and mortgage-backed securities prices lower.

Calling it "boredom in the bond market" would oversimplify the explanation but the description seems to fit well. Traders got ahead of themselves and now the market is minding its time with some tactical short selling ahead of more auction supply (which if you recall was the main reason why mortgage rates rose from new record lows after the long bond auction was poorly subscribed.)

We've been aware of this process since bond yields began to back up two weeks ago and we are not tying it to a shift in fundamental outlooks. We are PLAYING THE RANGE UNTIL BERNANKE PLAYS US

In 10s that range is between 2.46% and 2.60% with the potential for yields to travel up to 2.68% if liquidity really dries up and the long end of the curve can't catch a bid. In December FNCL 3.5s we're playing a price range between 101-00 and 100-00. Anything over 101-00 and we're in profit taking territory/locking up anything closing before November 3. On the other end, as 3.5s approach 100-00 we'd be more willing to float in anticipation of bargain buying ahead of QEII and Federal Reserve MBS reinvestments back into the TSY market.

Key Events Today:

9:00 ― The S&P Case-Shiller Home Price Index is expected show home prices in the 20 metropolitan areas it covers fell for the third consecutive month in August. In July, monthly prices fell 0.1%, indicating that prices were 3.2% higher than one year ago.

“Looking forward, demand for housing is expected to increase throughout 2011, but at a tepid pace,” said economists at BBVA. “As a result, home prices will appreciate from current levels, but will remain low.”

Economists at Nomura suggest the index has held up well in recent months despite weak sales. “We therefore expect growth in this measure to start to cool. We forecast that Case-Shiller prices rose by 2.1% y-o-y in August, down from 3.2% in July and a peak of 4.6% in May.

10:00 ― The more limited and less closely-watched FHFA House Price Index is anticipated to show that prices are down 3% versus last year. The index has fallen for the past three months. 

10:00 ― Consumer Confidence is expected to recover to 50.0 in October after shedding almost 5 points to 48.5 a month before ― the lowest score of the calendar year. The best September stock performance in decades should provide a boost, but with unemployment numbers remaining at 9.6%, it’s unlikely consumer expectations will rise much.

“Confidence remains fragile, and is being hurt by a weak labor market and by uncertainty over what will be happening to taxes next year,” said economists at IHS Global Insight, who predict a decline.

4:30 ― William Dudley, president of the New York Fed, speaks on the economy. In a speech Monday he said “further Fed action was likely to be warranted” unless the economic outlook improved soon.

OTHER EVENTS

• 10:00 Richmond Fed Manufacturing and Services Indices (Oct)
• 10:15 Fed outright Treasury coupon purchase (02/15/21 - 08/15/40) (e: $2.55 bln)

ISSUANCE
* 11:30 Treasury auctions $22 bln 4-week bills
* 13:00 Treasury auctions $35 bln 2-year notes
* Axis Bank, benchmark 5.5-year; BAML/Citi/DB/JP/RBS
* UBM, $500m 10-year; BARC/CS/HSBC/JPM
* Lukoil, Eurobond offering; Barc/ING/RBS
* Fortescue, $2.04bn 5-year; JPM/RBS; roadshow this week
* CODELCO, issuance expected following roadshow; DB/HSBC