Tuesday, November 6, 2012

2 Forces Battling In The Treasury Market - Friday's Large Buyer vs This Week's Auction Setup Sellers

With this week seeing 2 of the largest DV01 events of the month on Wed and Thurs (24bln 10yr and 16bln 30yr bond auctions), the large buyer from Friday will have a tough opponent on their hands. 

Summary of forces to be concerned about in the US Treasury market today:
  • Friday's large buyer
  • Auction related setup sellers
  • The Fed (POMO)
  • COT Report spec longs
  • Risk RV (Stocks vs Bonds)
Typically, the majority of the duration setup (selling current bonds to make room for new issues) for the 10yr and 30yr auctions would be well on their way by now.  In a normal balanced market, this setup would cause the long end of the treasury market to selloff, creating a concession (drop in price) so that the new issues can be purchased at a discount.  This selloff / discount is normally required to absorb the duration of the supply.  This week however, we witnessed a large levered trader take a long position (on Friday post NFP) right ahead of the auctions.  The community of auction participants will still need to sell bonds ahead of the auction.  The question on everyone's mind is...will the large buyer from Friday be proved victorious (create a rally to sell into) or will the auction setup sellers force Friday's buyer to capitulate and liquidate his position into a falling market (this would be a violent downtrade).

Either way, Fridays buyer will be liquidating his position at some point, and the auction related sellers will be flat or long come Thursday's bond auction.  The only question is...does Friday's buyer liquidate at a high price (sell into a fear-based rally), or does he liquidate at a low price (sell alongside the auction concession).  At this point in the cycle, we normally look to risk assets to help give us a clue.

Normally, at this point in the cycle, the expectation is for UST to weaken substantially vs risk assets (S&P futures are usually a good barometer for risk appetite).  If that were happening right now (as we would normally expect it to), then the green line (10yr yield) on the above chart would be moving closer to the red line (S&P futures).  That hasn't happened yet.

With almost all global stock markets showing gains overnight...

I am not surprised that US treasuries have sold off a little. 

I am surprised that US treasuries have not sold off more, given that there are 2 large auctions looming in the next few days.  I blame this lack of concession on POMO and Friday's large UST buyer, who has thrown a wrench in the works of this auction supply process.  POMO will completely absorb this months long end supply.  There are some large auction related short positions that were established yesterday (avg price 133-04+ using ZN....99-14+ using 10yr notes).  At the moment, both of these positions (Fridays buyer and yesterdays sellers) are "in the money."  I suspect one side will press their position today in an attempt to shake out the other.  On a relative value / cyclical  basis, UST sellers have the upper hand.  On an "in the money" basis, Friday's buyer has the upper hand (starts off with more money in the trade).  

One other factor to consider..the CFTC commitment of trader's report.  This report released on Friday indicated the largest long duration position in the US treasury market since March 2008.  These spec longs are not permanent fixtures of the market.  These are traders...and traders like to trade.  This means that there is a large population of spec longs just waiting to sell their position.  They will either sell into a rally taking profits...or they will sell into a downtrade in a long liquidation.

In a market where "flow" is the dominating force, one of the above forces will push the others off a cliff in the not too distant future.  Stay tuned for the party....there should be a significant transfer of wealth coming soon.

This is frustrating for anybody who doesn't have a position yet, as the winner has not been announced.  I don't advise taking a position in the middle of this trading range.  I do advise going with the large trader from Friday.  Primary dealers are forced to bid for their pro-rata share of the auction, so they are forced to sell paper at some point to make room.  These primary dealers do not have room to take infinite P&L pain...sometimes they are forced to short cover too.  We spec traders are lucky in that we have no such obligation.  We can wait and see what the large trader does and follow in his footsteps.  If he sells ahead of the auctions, i'll sell too.  The winner of this battle will be known by a violent trade (either thru short covering from the auction setups, or a long liquidation from Friday's buyer), and this will be clearly visible to all.

For those interested in the worst / best trade for the dealers who traded yesterday:  the worst price action for the dealers would be a stock selloff / UST rally today that forces yesterday's sellers to short cover...and Friday's buyer simultaneously liquidates his position selling into the short covering rally.  If that plays out, then we should finally see a ripe opportunity to set our own short for the upcoming auctions.  Note how we would be selling alongside Friday's large buyer.  If we don't get that opportunity, well...money not made is better than money lost, i always say.

more later...govttrader out...

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