MBS RECAP: Impressive Correction Following Home Sales Data

“Short Covering/Profit-Taking” in Bond Markets: Traders with outstanding positions (aka “bets that rates will move higher or lower”) have “stops” in place (aka “levels at which they’ll automatically exit their positions–selling when prices fall after a rally or buying when prices rise after a sell-off”).

Even as 10yr yields hovered around 2.90 yesterday, there were (and still are) shorts in the market (those betting on lower prices and higher rates). When something like today’s New Home Sales report shakes things up and gets prices heading quickly higher, these short positions may decide (or may be automatically set) to buy at a certain level, thus protecting the gains from the bet they may have made when rates were 10-40 bps lower, or to protect against further losses if they took out a short position yesterday).

When shorts are covering/buying it can further add to the rally that they’re attempting to avoid. Thus the remaining shorts are that much harder-pressed to cover, and snowball buying is born. This can be made even more acute if there’s a lack of supply for interested buyers (remember, those covering shorts are exiting/covering positions by BUYING). Well guess what… There hasn’t been an awful lot of supply in MBS recently for reasons you’re already painfully familiar with.

The net effect is simply longer legs and a faster running speed for a rally that would probably not be quite so fast or big. Sometimes snowballs roll in our favor. Today is one of those days, but keep in mind that it looks more impressive than it otherwise might, if not for massive amounts of short-covering on a day with seasonally low participation.

The fact that 10yr yields fell PERFECTLY back to Wednesday’s pre-FOMC levels is the biggest clue that we’ve just seen a rapid flushing out of short bets. There’s more liquidity in Treasuries than MBS, and illiquidity exacerbates the effects of short-covering. Hence, MBS are pushing new highs while TSYs drift sideways, having more efficiently covered their shorts and moved on with life and the weekend. This could eventually happen for MBS this afternoon, so don’t rule out a late pull-back just because the rest of the day has been so stellar. More importantly don’t assume that today equates to a thematic shift, or bounce off recent rate highs. That CAN happen, but it will take similarly lackluster data next week, and even then would only be a consolidative move before Sep 6’s NFP casts a firmer vote.

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Article source: http://www.mortgagenewsdaily.com/mortgage_rates/blog/321962.aspx

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