“You dropped a bomb on me baby”…The Gap Band. And boy, what a bomb it was. This Tuesday, Mortgage Bonds had their worst one-day performance since October, losing an astounding 206bp. So…what the heck happened and what’s next?

The main culprit for yesterday’s selloff…SUPPLY. The Treasury has literally been printing money by way of Treasury auctions to pay for the massive spending. And these hundreds of Billions of dollars of new Bond supply have to be absorbed by the market, so the additional supply literally weighs on the entire Bond market and drags bond prices lower. Also, when you think of SUPPLY, consider there have been tons of refinances and all those loans have been bundled, packaged and sold on Wall Street…and this additional SUPPLY has now started to hit the secondary market, as those closed loans are now getting turned around and sold. This supply also must be absorbed, and while the Fed has been a buyer, they simply can’t buy enough to balance all the selling. It’s Economics 101, anytime supply vastly exceeds demand, prices will move lower. And as prices move lower, yields rise – that rise in yield will attract new buyers as they get a higher return on their investment – higher yields… higher interest rates. This is how the market finds balance.

After losing a staggering 363bp since last Thursday (206 of which happened yesterday), Mortgage Bonds are bouncing higher this morning.

The question on everyone’s mind… Will rates come back? The answer is that we will probably see some improvement, but it will be difficult to see rates fight back to the levels they were at just last week. There are both fundamental and technical reasons why a retracement back to last week’s levels would not be easy. Fundamentally, the aforementioned supply issue still exists, with no end in sight to the amount of debt still to be issued – the printing presses are just getting started, and the Fed now has to almost endlessly push sales of Bills, Notes and Bonds to raise the capital needed to continue to spend. Yes, the Fed will continue to buy Mortgage Bonds, which will help to some degree but… put your traders cap on for a minute, and think about this. If you were a trader, and saw that US Treasury yields were moving up, up, up “making them more attractive” and Mortgage yields were moving lower, you would be tempted to sell your Mortgage Bonds and buy Treasuries. This is precisely why the Fed announced that they will be buying $300Billion in Treasuries in addition to the Mortgage Bonds – to protect against this. But it’s like trying to clean up a flood with a sponge.

Moreover buying long term Treasuries at the same time they are trying to sell them has got to make you wonder who came up with this bonehead idea? Especially since the Feds efforts should have been to sell as much long term paper as possible, when they could have locked in paying rates of 2%! You almost wonder why the government chooses not to act like a normal rational consumer or homeowner it makes no sense whatsoever. Would you advise your clients to pass up a 2% rate on a 30 year fixed loan, and opt for a 1% rate on a six month ARM with no caps on future rate increases when they are planning to remain in the home forever? This is exactly what the government is deciding to do.