The Day Ahead: Basking In QE3 Afterglow, Enduring A Busy Morning Of Data


After yesterday’s massive QE3-inspired rally took production MBS to NEW ALL TIME HIGHS, it might seem a bit anticlimactic to wade through a relatively busy Friday of economic data.  Indeed the critical factor in “the day ahead” (and probably even in the week ahead) has more to do with the day just passed.  In other words, observing the tradeflow patterns and preferences in response to the MBS-specific QE3 is more interesting than the average economic release today.

To set some sort of baseline, we’d say that we think markets did an extraordinarily good job of processing an epic day of transparency, communication, and utilization of policy tools.  The announcement delivered on both of the market’s expectations in that it A) was open ended and B) extended the ZIRP verbiage.  The fact that it neglected Treasuries, preserved MBS reinvestments, AND added additional non-sterilized MBS purchases to the mix means that the Fed is essentially now TWICE AS BIG a sponsor of MBS as before.  Regardless of our skeptical long term views on this band-aid, it’s very soothing in the short term.

And it’s not even that mortgage markets were in need of soothing, per se.  Rather, the Fed knew they wanted to do “something,” and it didn’t make much sense to target Treasuries for a few reasons (their buck buys a bigger piece of the MBS pie and they’re running low-ish on twistable Treasuries).

If you’d told us yesterday morning what the Fed’s plan would be, the easy part to call would be the tightening of MBS to Treasuries.  Tightening refers to the yields of MBS and a comparable duration Treasury security getting closer together.  If 10 yr yields held in the low 1.7’s by yesterday’s close and MBS yields fell about 15bps from, say, 2.65 to 2.50, MBS yields would now be much tighter to Treasuries. 

These spreads bottomed out in mid 2009 and 2010 and had slowly crept up until the Fed announced Operation Twist last summer and began reinvesting MBS income back into new MBS purchases.  Spreads never made it back to historical lows however, and had essentially drifted slowly wider to some of their higher level of the past 3 years (still nothing compared to the pre-Fed days).  Yesterday’s QE sent spreads tighter than they’ve been, EVER. 

The harder thing to know about QE3 is where bond markets would generally trend.  To that end, we find the 10yr yield not quite as high as it had been in mid August and not quite as low as it had been during any other part of the summer.  1.7’s in 10yr yields “feels” about right for a global market with some European hopium (that gets us up out of the 1.5 area), but still with plenty of risks that the hopium turns out to not do the trick (that keeps us from definitively re-entering the 1.80-2.1 range that dominated much of the past 12 months. In short, the market’s reaction makes a lot of sense. 

It will be interesting to see what sort of effect today’s economic data will have after yesterday’s news.  The normally big Retail Sales report hits at 8:30am along with Consumer Prices.  Industrial Production arrives at 9:15am and Consumer Sentiment Prints at 9:55.  European finance ministers will be meeting to discuss whether or not Spain should request a bailout from the ECB, an event that has as much potential to affect trade as anything else today.

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