Next Week's Treasury Supply

The Fed's decision last week to start reinvesting the proceeds of its maturing MBS securities in Treasuries has triggered a significant rally in the government securities market with a sharp flattening of the yield curve- both entirely predictable developments.

In assessing today's yield levels, lower by nearly 30 basis points in the 10-year sector (and by about 35 basis points in the case of the long bond) since August 9, it is tempting to argue that the market may feel somewhat vulnerable ahead of next week's 2-, 5-, and 7-year auctions. After all, the three auctions represent a combined total of $102 billion of supply (supplemented by another $6 billion of a re-opened 30-year TIPS auction on Monday).

Still, that temptation should probably be resisted, for three reasons.

1) Supply per se has rarely been a factor that alters the direction of a trend in yields; it can cause hiccups, but not change the underlying dynamic of a potent move. The latter, in this case, is fueled by the sensible perception of a cooling momentum in the economic recovery. The economic data on next week's calendar are quite unlikely to challenge that perception, as existing/new home sales and durable goods orders are notoriously noisy and any unexpected strength in those reports is likely to be viewed cautiously and produce only a very limited reaction. Friday's University of Michigan consumer sentiment index is simply the final number for August and highly unlikely to deviate appreciably from its early-month reading of 69.6. This leaves us with initial claims, which, given their current level of 500,000, should be expected to show a decline of 15,000 to 20,000 anyway- a fairly uneventful development.

2) With the market's state of mind about a downshifting in economic growth likely to remain intact next week, the current yield levels can still be viewed as reasonably attractive, particularly for the 5- and 7-year sectors (although admittedly less so for the 2-year at 48 basis points). Despite the dramatic flattening of the curve since the day prior to the FOMC announcement, the 5- to 7-year sector remains attractive on a carry basis (roughly 120 and 180 basis points respectively over their financing costs). The cushion is substantial enough to absorb any backup of the market in the coming weeks associated with either a headline risk or a wickedly strong key economic report. Both maturities should continue to be underpinned in the coming weeks by their status at the center of the Fed's newly activated reinvestment program of its maturing MBS holdings.

3) With the plain vanilla carry trade already appealing in its own right, continuation of the recent stream of soft economic reports can keep the debate over deflation and/or a "double dip" scenario alive and cause the rally to be extended further, making the 7-year sector, in particular, well positioned (along with 10s) to capture that move.

Nervous as one always feels about a market going into heavy supply nearly at its highs, it is hard to come up with solid arguments about a meaningful back up in yields (not of the simple hiccup kind) that would make those who bought next week's auctions regret it in the next few weeks.

Anthony Karydakis