A volatile week in bonds ended about where they began. It was shaping up to be another crushing week for bonds before a rally late in the week. The ten-year traded as high as 3.56% on Thursday morning before rallying to 3.41% by the end of the day. Volatile trading sessions are likely to define the market into the New Year.

QE2 continues to run strong with another $105 billion scheduled to be bought by Jan. 11, right in line with estimates. Higher Treasury yields have pushed 30-year mortgage rates above 5% for the first time since April, which should result in lower prepayment speeds on MBS. Slower prepays means less money needing to be reinvested in Treasurys by the Fed, which could mean less QE going forward. The initial estimates for QE2 were for ~$75 billion/month in total Treasury buying, with ~$25 billion of that being reinvestment of principal from the QE1 MBS portfolio. On the other hand, the Fed could keep purchases running at $75 billion/month despite a slowdown in shrinkage and end up with a larger balance sheet as a result. I’m not going to act like I have a clue what “Helicopter Ben” will do.

Municipals

Year-end issues in the bond market are normal, as dealers lighten up their inventories and banks position their balance sheets for the end of the year. The typical result is increased volatility and wider bid/ask spreads, and for the most part the dislocation is corrected in early January as the market returns to a more normal operating environment.

The most dislocated of all bond markets, the muni market, which during the best of times is still chaotic, has been affected more than most of the market this year because of two main issues surrounding the most recent tax bill passed by Congress and signed by the President today.

First, an extension of the Build America Bond (BAB) program is not included in the tax bill that passed. The coming expiration of the program caused a large number of issuers to come to the market in a short amount of time, sparking a selloff as buyers demanded higher yields to absorb the additional supply. Bond issuance commonly comes in chunks, and market usually finds equilibrium soon after the initial selloff, but this could be the end of BAB issuance. Without new issuance, the BAB market will take a backseat to the active muni market, and the added risk premium built into issues during the last big push of issuance could be permanent if the Federal subsidy goes away for good. The BAB market was a big plus for the state and local governments that issued them because it expanded the universe of muni buyers beyond traditional top tax bracket Americans. The permanent loss of an active BAB market would be a negative for the entire muni market.

Secondly, the traditional tax exempt municipal market enjoyed an amazing rally earlier this year as rates fell across all classes of fixed income and investors rushed to capture the income tax exemption ahead of the expiration of the Bush-era tax cuts. Interest rates are higher after this most recent move, especially in the longer end of the curve where munis are most commonly issued, and the expected tax hike that drove high quality municipal bonds to yields lower than Treasury bonds are now delayed for at least two years. Some of this selloff in munis is just bringing an overbought market back to more sustainable levels.

The credit issue for municipalities hasn’t gone away either. It’s not the catalyst for what’s going on the market right now but if concerns about state debt loads come back to the forefront it could cause more selling.

That said, even if the muni market remains weaker for a long time, these levels could still represent a good long term entry point. Relative value has been a very difficult thing to capture in this low rate market, and although rates have risen recently they still sit very low on a historical basis. The Fed is still dominating the bond market as the largest buyer of Treasury debt, and as long as that continues relative value will remain hard to find.

Have a great weekend.