Bond rally nearing an end?

Am I missing something or has there been a significant impact on the treasury market from the demand for collateral to support structured credit products. As massive amounts of money go into virtual credit instruments, there is a need for risk-free collateral that you would not have if traditional fully funded credit products ware used. Although prime brokers are more lenient than they used to be about collateral (they will accept leveraged loans, and supposedly accept aaa-rated CPDOs – insane!!), government/agency paper is the norm.

It seems like looking at the treasury market - without taking account the influence of notional funded spread products – can be dangerous. Many of the buyers of treasuries are somewhat price insensitive at this point. But in the event of spread widening there could be some massive convexity effects hitting treasuries.
 
Quote from JohnL111:

Am I missing something or has there been a significant impact on the treasury market from the demand for collateral to support structured credit products. As massive amounts of money go into virtual credit instruments, there is a need for risk-free collateral that you would not have if traditional fully funded credit products ware used. Although prime brokers are more lenient than they used to be about collateral (they will accept leveraged loans, and supposedly accept aaa-rated CPDOs – insane!!), government/agency paper is the norm.

It seems like looking at the treasury market - without taking account the influence of notional funded spread products – can be dangerous. Many of the buyers of treasuries are somewhat price insensitive at this point. But in the event of spread widening there could be some massive convexity effects hitting treasuries.
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Not really sure what you try to imply with convexity effects.
As for structured credit you are a bit behind the curve - Treasuries are recently rarely used because you are not be able to give competitive pricing with Tsy collateral (at least for correlation products). Today with spreads that tight you need to cannibalize even on collateral.
 
Quote from mcurto:

Volume was heavy as reported by ICAP on cash, I think something like 200 billion traded and futures in all contracts were heavy volume. The 10yr was still trading good size into the afternoon, probably 500,000 contracts from Noon onward. 1.5 million contracts in the 10yr alone is a HUGE day (average is normally around 700,000 and this time of the year usually only 500,000). I really wouldn't put too much stock into ANY of those reports you listed. They just give typical reasons around this time of the year when they have no clue what is actually happening in the markets. Yesterday was a very heavy volume day with two-way flows and very poor price action for bulls.
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I agree with your volume comment - it was massive. I also agree with the short covering mentioned by Lance (unfortunately I was part of it). I just do not get the price action - every day in the past year you would never see selling into these data - maybe PIMCOs Bunds selling was the partial reason; quadruple witching probably did not help either...
 
I'm not sure if this has anything to do with the structured credit stuff but Wells Fargo has been getting bigger and bigger every quarter with their convexity hedges for their mortgage portfolios.
 
It just seems like the ridiculously low vols in treasuries have been correlated with the perpetually tight spreads. The assumption is that if spreads widen, it will be in a nice orderly fashion and no one will get hurt too badly. But it's like hedging a short otm put – as long as the delta remains small it looks easy to hedge. But a short gamma (convexity?) position can quickly blow you up if prices move to fast. In the case of bonds, the bullish flight to quality effect would be overwhelmed by the need for liquidity in the credit derivative products. The resulting liquidity crunch then starts a vicious cycle until someone stops the madness. Given the unprecedented growth in OTC credit contracts, I am not sure who can really step in and reassure the markets. It makes LTCM look like an average retail fx trader.

I mean you are reading every day about hedge funds who are leveraging up their billions 10-20x and only make 20% a year? Come on, this seems like way too much risk for that return.
 
Quote from JohnL111:

It just seems like the ridiculously low vols in treasuries have been correlated with the perpetually tight spreads. The assumption is that if spreads widen, it will be in a nice orderly fashion and no one will get hurt too badly. But it's like hedging a short otm put – as long as the delta remains small it looks easy to hedge. But a short gamma (convexity?) position can quickly blow you up if prices move to fast. In the case of bonds, the bullish flight to quality effect would be overwhelmed by the need for liquidity in the credit derivative products. The resulting liquidity crunch then starts a vicious cycle until someone stops the madness. Given the unprecedented growth in OTC credit contracts, I am not sure who can really step in and reassure the markets. It makes LTCM look like an average retail fx trader.

I mean you are reading every day about hedge funds who are leveraging up their billions 10-20x and only make 20% a year? Come on, this seems like way too much risk for that return.
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Well, I agree that risk/reward ratio got out of proportion a bit. But I do not believe in any doomsday scenarios - of course spreads are going to go wider one day. But the market is nowadays very deep and all will go smoothy - just recall how invisible the last few big defaults were. And in some cases CDS/Bonds multiple was more than 10.
By the way there are many good reasons why spreads are so tight. Of course there are also bad reasons, like CPDOs.
 
At least as swap spreads have been narrowing since the summer from around 60 basis points to the 10yr treasury to less than 50 basis points now the trend in volatility (Merrill MOVE index) has been upticking, albeit very slightly. I do agree though, lots of risk out there, Goldman prop is the perfect example in the 10yr options, basically short 75,000 straddles ATM and OTM at around 4.0 to 4.5% in 10yr vol, where are we going, to 2.5 or 2.0% vol? Then the long end of the Treasury curve will be moving like the 2yr and 5yr notes, with whopping couple tick ranges on slow days.
 
Quote from JohnL111:

It just seems like the ridiculously low vols in treasuries have been correlated with the perpetually tight spreads. The assumption is that if spreads widen, it will be in a nice orderly fashion and no one will get hurt too badly. But it's like hedging a short otm put – as long as the delta remains small it looks easy to hedge. But a short gamma (convexity?) position can quickly blow you up if prices move to fast. In the case of bonds, the bullish flight to quality effect would be overwhelmed by the need for liquidity in the credit derivative products. The resulting liquidity crunch then starts a vicious cycle until someone stops the madness. Given the unprecedented growth in OTC credit contracts, I am not sure who can really step in and reassure the markets. It makes LTCM look like an average retail fx trader.

I mean you are reading every day about hedge funds who are leveraging up their billions 10-20x and only make 20% a year? Come on, this seems like way too much risk for that return.
More...

A multi-trillion dollar market for derivatives, and not all of it hedged but outrights, doesn't bode well if it outpaces the underlying market. The backoffice is still trying to tie these puppies out, months after they've been initiated. Having said that, the doomsday scenario has been around for years, so I don't think Tomorrow is gonna be day of days. Even the Amaranth story was a success story in that the treasury didn't have to bail out the system on a much bigger loss than LTCM. In the end, the Amaranth positions (complex instruments as they were, I believe they were still just betting on spreads) will be covered over a period of months and at a big loss, but at least it will be orderly... The grapevine says Brian Hunter is job hunting again...
 
I agree that it is impossible to say when the liquidity issues will surface. But if you look at a market like EM debt where leveraged funds account for maybe only 20% of the open interest but over 50% of the daily trading – it seems like there is no way real money investors would accept less than 200bp over benchmark rates. But it has been stuck at record low spreads for some time. Could one reason for the spread compression and hedge fund activity be the influence of CDS markets?

As real money accounts move their allocations from traditional FI to alternative managers, the markets are becoming inherently less robust to financial shocks. But this is the last thing people will be thinking as they eat their holiday turkeys. Merry Xmas!
 
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