Closing Comments October 29 2008

October 29th, 2008 5:00 pm | by John Jansen |

Prices of Treasury coupon securities moved in bifurcated fashion today as the carrot of a one percent funds rate seduced buyers into the front end of the market while the long end of the bond curve languished on supply fears and continued deleveraging by hedge funds.I want to take a second and discuss the deleveraging event and the anomalies it has fostered along the treasury curve. For many years traders have found it profitable to buy and sell zero coupon strips and do the opposite trade in the swap market. The August 2023 strip in the old days would trade 40 basis points rich to swaps when they were expensive and 9 basis points expensive to swaps when they were cheap.

That zero coupon strip is trading today at swaps plus 70 basis points. I spoke to a trader of that sector who said that the deleveraging continues with full force and he does not expect it to abate until year end.

Here is another example in the same sector except that this is with a whole bond as opposed to a zero coupon. The treasury has a bond which matures in 2026 which began its life as a 30 year bond and has since rolled down the curve as all good bonds do. That bond yields 4.60 percent. The entire spread between the active 10 year and the active 30 year bond is about 39 basis points. This bond trades 76 cheap to the 10 year so you practically double the entire 10/30 year spread by extending just 8 years.

Similarly, one could on a positively sloped yield curve sell the current 30 year and back up 12 years and pick 37 basis points.

These types of anomalies can only happen because of forced selling and because the buyers of the positions do not have balance sheet room to sit with the trade until it performs.

Earlier I wrote about improvement in the agency market and the corporate bond market. Those markets can improve, for sure, but a significant and seminal turn around, in my opinion, is unlikely and improbable until these very cheap sectors of the Treasury curve normalize.

The yield on the benchmark 2 year note slipped 10 basis points today to 1.54 percent. The yield on the benchmark 5 year note dropped 9 basis points to 2.71 percent. The long end of the market stagnated as the yield on the 10 year note was essentially unchanged at 3.84 percent. The yield on the 30 year bond edged higher by 4 basis points to 4.23 percent.

The 2year/10 year spread widened to 230 basis points.

The 2year/5year/30 year butterfly stands at 35 basis points. There is an auction tomorrow of $24billion new 5 year notes. The roll is 5 basis points and the butterfly with the WI is about 25. There should be strong interest from the arb community as the spread moves inside 20 basis points.

Five year and ten year swaps are tighter by 5 basis points to 6 basis points today.

Mortgages performed well early but crumbled under the weight of real money and speculative selling. They lagged swaps by about 5 basis p

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  1. One Response to “Closing Comments October 29 2008”

  2. By David on Oct 29, 2008 | Reply

    Any idea why the deleveraging has to end by years end? I don’t understand where Hedge funds are going to borrow from in the future. Are banks still going to lend to them? Do most of these funds even have a viable business model without cheap money?

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