The bond market short-squeeze is making it cheaper to get a mortgage
– Ben Eisen, January 30, 2014, 1:27 PM
Bonds have staged an incredible rally this month, pushing Treasury prices higher. Yields on the benchmark 10-year note 10_YEAR +0.26% are down from over 3% at the beginning of the year, to 2.7% on Thursday. As yields fall this month, you may have noticed it’s getting cheaper to take out a mortgage.
But a good portion of the bond rally can be explained by the way investors positioned their holdings going into 2014, and a resulting short-squeeze as they unwind their positions.
As we rang in the new year, investors celebrated by betting that rates would continue to rise — a sentiment shared by nearly everyone, from Wall Street traders to your grandmother. Investors get short if they think rates are going to rise, and the CFTC Commitments of Traders report showed that investor net positioning was among its most short in recent years at the end of 2013.
Take a look at the below chart, courtesy of LPL Financial, which has a great note to clients about the phenomenon this week. The green line dips deep into negative territory at the end of 2013:
That bearish positioning for higher rates caught investors on the wrong side of the trade as Treasury yields took their cue from some negative indicators and started dropping. First, a disappointing employment report showed the weakest job creation in three years. Then, worries about growth in emerging markets pushed investors into the safety of U.S. government debt. We’ve also seen signs that pension investors are moving back into bonds, helping support the market.
When rates began to point lower and prices higher, investors who had gotten short the market began to unwind their positions and buy the very government debt they were holding their nose at, helping accelerate gains in the market. That’s often called short covering, or a short squeeze. Anthony Valeri, market strategist with LPL Financial, writes in a note:
“As bond prices rise and interest rates fall, defensively positioned investors may see their portfolios likely lag benchmark performance. Investors then would likely buy to get closer to their benchmark in order to limit underperformance to a benchmark. Bond buys to get portfolios closer to neutral may have aided bonds in early 2014. When coupled with fundamental drivers, positioning and sentiment can be a potent combination.”
But as the chart above shows, the negative positioning has been largely reversed. The next logical question is whether the rally will continue and your mortgage rate will keep falling. The short answer to that: The market moves in mysterious ways, so trying to time a market reversal may catch you offsides, just like those traders who got short-squeezed.
Since you asked, though: The more neutral positioning of investors doesn’t necessarily mean the market will reverse. It just means that the direction of yields will revert back toward the fundamental data and underlying economic outlook that generally drives the market.
That economic outlook is a bit more murky than it was heading into the new year. Even if the economic data in the U.S. becomes stronger, the outlook for emerging markets is bleaker. The Federal Reserve’s withdrawal of its bond-buying stimulus, which is poised to continue winding down this year, has helped pull capital out of emerging markets as investors exit those markets. Strategists say that if the bond market takes its cue from emerging markets, Treasurys may continue to gain.