Many Questions - No Answers

Another absolute pasting in the bond market today. I have been anticipating something along these lines, but this is happening much faster than I expected. I suspect we are near a tipping point . Either the run on the long end abates and we find a new trading range or the 30-year is going non-stop to 5%.

There is an interesting little sideshow developing. QE-Lite is getting smaller by the day. This program is the balance sheet top off of the original QE where the Fed bought MBS. Mortgages prepay when interest rates fall. But the rate of prepays declines sharply when rates go back up. In addition, the mortgage gate problem has gummed up the process and we are now in the holiday period where, by recent tradition, the bankers prove they are nice guys and suspend all foreclosures.

How much are prepays declining? How much does it knock off the estimates for QE-Lite related Treasury POMO buys? Good questions. You can be sure that there are a bunch of deep thinkers in the bond market who are trying to figure this out. There were estimates that this would total as much as $300b through 6/30/11. Whatever your estimates were, you have to cut them today, by a third to a half. Does it matter if the sum of QE-2 and QE-Lite is reduced by 100/150b (10-15%)? I’m not sure. But it’s a new wrinkle in the puzzle.

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I keep an eye on the relationship of the 10-year bond and the S&P. From time to time this pair shouts out about stress. That the lines crossed today may not be significant. But it is an interesting milestone.

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Last summer there was a period of time where the bond’s performance lined up perfectly with the S&P. Strong bonds = Weak stocks. Then the correlation went away. But now it has come back. It is the exact opposite today than when it was warm. Now we have Weak bonds = Strong stocks. Does this mirror image repeat performances mean anything? We shall see. In the past, the correlation breaks (hard). The question is, which leg moves where?

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