New Concern

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At 7:00 this morning the 10 yr note yield was at 2.28% +7 bp frm yesterday’s close; at 9:00 the note improved to 2.24%. US, Europe and Asian stock market all being hit hard today; at 9:00 the DJIA was-115 frm yesterday’s close pointing to a very weak open at 9:30. At 9:30 the DJIA opened -139, NASDAQ -44, S&P -18; the 10 at 2.25% +4 bp and 30 yr MBS price -34 bp frm yesterday’s close. The new concern this morning is being triggered by news frm the Bank of Japan overnight that it left its monetary policy unchanged, markets apparently believed the BOJ would increase its stimulus. In Germany its high court is set to review the legality of the ECBs Outright Monetary Transactions. According to plaintiffs and those opposed to the ECBs bond buying it is against the principle of constitutional democracy. Those asking the high court to rule are saying they know it will roil financial markets but it is necessary to preserve Germany’s democratic constitution and that the ECB independence is not constitutional in Germany. The OMT funds have yet to be used and were originally put in place when Italian and Spanish 10 yr bonds exceeded 7.0% The as-yet-unused OMT foresees potentially unlimited purchases of bonds of debt-stricken countries that sign up to adjustment programs. The BOJ left monetary policy unchanged, the yen is strengthening. Speculation, at least this morning, is that central banks will fail to keep the global recovery on track. Here we have speculation that the Fed is about to begin withdrawing its stimulus; so far all the money printed by the Fed has had only a minor positive impact on our economy. In Europe the ECB left its base rate unchanged when it met a ago. Now Japan, expected to pump barrels of yen into the markets has unexpectedly decided to not increase its stimulus. A  news story on Bloomberg this morning saying that interest rate increases will prompt investors in mortgages to sell treasuries as a hedge against losses that are growing in the MBS securities. Late to the party if MBS investors are now just beginning to think about hedging. Last week SF Fed President John Williams said in a speech that he thought the Fed would begin to slow purchases of MBSs as early as this summer. As rates increase, the potential for refinancing mortgage bonds and loan-servicing drops, extending the average lives of the securities and leaving holders more vulnerable to losses. Investors then may seek to pare the duration risk or rebalance existing hedges by selling longer-dated treasuries, mortgage bonds or transacting in interest-rate swaps or options on those contracts, sending yields higher and spreads wider. There is an increasing number of analysts, traders and investors that are beginning to see the light; that when the Fed and other central banks have to end their market manipulation by all the purchasing of treasuries and mortgages it will cause a huge re-adjustment in investor thinking about the future of the stock markets and global interest rates. There are no economic data today except April wholesale inventories at 10:00. The estimate was for inventories to have increased 0.2%, as reported inventories increased 0.2% while sales were up 0.5%. This afternoon Treasury will sell $32B of 3 yr notes, the first of three auctions. Tomorrow $21B of 10 yr notes, the demand will be crucial to how the 10 yr trades. Thursday $13B of 30 yr bonds. Yesterday’s high yield at 2.23% matched its previous high last week; very early this morning the 10 yr shot up to 2.28% setting another breakout into new high rates. We are now hearing the 10 yr may climb to 2.40% before another pause. No forecast from us at this time; we have warned for over a month that rates would increase but until this morning our worst case target was 2.25% for the 10 before a potential rebound. Unless there is improvement today from early morning levels the increasing bearishness is likely to increase as markets now are fully understanding that artificial stimulus frm the Fed and other central banks have distorted normal market functioning. There is always a heavy price to pay once the rug is about to be pulled out from under central bank supports. We have been recommending a strategy of floating as long as the 3.5 June FNMA coupon held over 103.00; this morning it is below the support. Unless there is a rebound by the end of the day, we can’t continue with that idea. So far for the past two weeks we haven’t given up anything by floating, nor have we seen any improvement. There is less reason now to float and any retracement is not likely to reap rewards commensurate to the increased risks. Keep close today and be prepared to abandon ship.