Treasury prices closed lower yesterday, with weakness led by  5- and 7-year notes.  The 2s/10s spread was roughly unchanged, as the yield on both notes rising by about 1.5 basis points.  The 5-year yield rose by 3 basis points, however, as investors continue to adjust to the reality of a market where the Fed is the driving buyer.  The 2-5-10 butterfly ended up at -19  bps; while still negative, the 5-year has clearly cheapened to the other maturities relative to where it was in September, when it approached -40 bps.

The selloff was triggered a variety of factors.  A rally in equities, due to optimism over a bailout of Ireland and the GM IPO, led to reduced demand for Treasuries.  The economic data was also relatively strong, as the Philly Fed index reported sharply higher than expected.  Positional pressures and a rise in implied volatility were also a main motivation of market flows. The 10-year yield scraped against the 2.96% level mid-day before ending up around 2.90%.

Agency MBS continued its repricing, with 5% and higher coupons flat to higher on the day while "rate sheet influential" coupons lagged.  Investors seem convinced that prepayment speeds will slow fairly quickly, as evidenced by both the adjustment in the coupon stack and the lack of volatility in dollar rolls.  Current coupons were also pressured by a pop in implied vols; swaption vols were up 2-3 basis points across the surface, reflecting fears as yields approached support levels.

The stock market was pushed up yesterday after Ireland indicated it would accept monetary support from the EU. Also, the TARP-saved General Motors hosted a successful IPO, and new economic data showed jobless claims come in lower than anticipated and a regional manufacturing index from Philadelphia kick way higher than forecasts. But European debt concerns are back, and so are worries the China may take actions to stem inflation by increasing bank reserve requirements.

“The [Chinese] central bank said this morning that it will raise banks’ reserve requirements by 50 bps to 18.5% as it attempts to cool inflation pressures,” said economists at BMO Capital Markets. “Meantime, Hong Kong is imposing additional tax and down payment requirements on residential properties in an attempt to cool speculative activity — properties sold within six months of purchases will face a 15% duty. As a result, yesterday’s risk appetite is not carrying over into this morning.”

The S&P 500, which jumped more than 18 points yesterday, or 1.54%, is set to open 4.50 points lower at 1,193.50. The Dow, which climbed 173.35 points yesterday, is 53 points lower at 11,123.

The 2s/10s yield curve is 3bps flatter at 237bps. The 5 and 7 year notes are both trading near UNCH on the day while the long end of the curve catches a bid.  The 10-year note is +6/32 at 97-26 yielding 2.881% (-2bps) and the 30-year bond is +15/32 at 99-29 yielding 4.257%. The FNCL 4.0 is +3/32 at 101-10.  Overnight trading volumes were well-below average.

Investor focus is likely to remain on foreign events and speeches today, as no significant economic data is scheduled for release, this implies we should be expecting continued volatility in bond trading. 

EVENTS...

• 5:15AM Fed Chair Bernanke on monetary policy and "Global Imbalancing"; Frankfurt, Germany (recap to follow)
  
• 5:45AM Fed Chair Bernanke in panel discussion at 6th ECB Central Banking Conference (recap to follow)
  
• 10:15AM QEII Treasury Coupon Lift: Fed buys $1.5 to 2.5 billion Treasury coupons maturing between 08/15/28 and 11/15/40