Has anything changed?

Many questions have been asked as to why there was such a dramatic move to higher US Treasury yields last week. And amid those questions there have been many statements as to how the bond market will perform for the next quarter.

Firstly, as I pointed out last week, the "Big Compromise" does little to change the trajectory of the US economy and over the past week we have seen further political polarisation in the US over the increase in the Debt Ceiling.

Yesterday's release of the NFIB Small Business Optimism Index continued to show the effects of all the political wrangling has had on business confidence and the survey's Hiring Plans sub index fell dramatically. With two months of wrangling over the Debt Ceiling even before the spending cut discussions kick in, US Business confidence is not going to be improving. The damage has and is continuing to be done to the US economy by the political stalemate.

So after 10yr US Treasury yields hit 1.97% before the US market open on the 4th January, there has been a steady move lower in yields and back to 1.87% in the 10yr.

So where did the selling come from. It seems to have come from holders of Mortgage backed bonds. The Fed minutes released on Thursday, caused doubts to be cast on the longevity of the Fed's purchases of MBS. Whilst probably wrongly construed by the markets, the MBS holders had under hedged their positions it seems, as they expected a risk free holding period. The selling of MBS caused a larger knock-on selling in US Treasuries, culminating in the hitting of the 1.97% just ahead of the release of the US Employment report.

As the report shows little signs that the Fed's 6.5% Unemployment rate target will be reached anytime soon, the market has now become more relaxed that the Fed will still be buying MBS and US Treasuries for at least the first half of 2013.

The rally which has continued since Friday comes in the face of US Treasury supply this week of 3yr, 10yr and 30yr bonds. As such the market is probably being held back by this supply from rallying further. Certainly the rise in 10yr and 30yr yields last week will have given the market a decent enough auction concession for the auctions to be a success this week. And with the Fed continually buying this week as well then yields should decline after the auctions.

Another sign that the US Treasury yields are set for a further decline are the movements in Europe and other Dollar bloc countries.

10yr Australian bonds have outperformed US Treasuries by 10bp since the end of the year. And Canadian 10yrs have outperformed the US by 3bp. Something that is counter intuitive to a sell-off caused by an increase in global growth prospects. If US Treasury yields really are on the rise than both of these markets would be underperforming and Canadian 10yr bonds would be trading 10bp to 20bp above US not just the 3bp currently.

Similarly German Bunds have continued to outperform US Treasuries, and 10yr US yields remain close to 40bp above Bunds. Peripheral bonds have had a good start to the year but now questions will be being asked again. Spain announced that it plans to issue Euro 121.3bln in bonds in 2013. That is 31.3bln more than it previously forecast and 25bln more than in 2012. It is also around 30bln more than the market was expecting. With the FT running an article from  Juan Rubio-Ramirez, professor of economics at Duke University and a researcher at FEDEA in Madrid, questioning whether the genuine structural changes have occurred in Spain at all, Spanish bonds are once again under pressure. That pressure will grow in coming weeks and drag other peripheral debt markets with it.

Most importantly perhaps are the continued signs from the Fixed Income Derivative markets that all is certainly not well. Implied volatility remains elevated and if anything is moving higher again.

I would expect that the yield curve in the US flattens after the auctions this week- and that should increase implied vols even more. At some stage this has to feed through into the complacent US risk markets.

So look for US Treasury markets to rally after the supply has finished. 10yr US Treasury yields should move back into the 1.85%-1.60% range again very soon.

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