It was a volatile week to end the year, thanks to the Treasury auctioning $99 billion in coupon securities during the least efficient trading week of the year. Bonds bottomed on Tuesday after an awful 5-year auction that caught the market by surprise and left the street with 58% of the new cusip, the previous 4 auction average was just 45%. The two-year and ten-year topped out on Tuesday at .75% and 3.49% respectively.

Longer dated Treasurys were the best performing sector in bonds, while Credit, MBS, TIPS and Agencies all underperformed the benchmark.

On the QE2 front, the Fed bought $103 billion in Treasurys in December, a little higher than initial estimates. The uptick in rates are likely to slow principal payments on the Fed’s MBS portfolio going forward, so subsequent buying should settle closer to the $90B-$95B/month range.

It’s interesting to think about where rates go from here. Comparing the most recent rise in rates to a similar movement late last year shows how, despite bonds selling off in both periods, we are in a much different place fundamentally.

The two-year sold off hard in December of 2009 as expectations for a reversal in Fed policy gained steam. The short-end remained volatile as 2010 began but buy the end of March the market was beginning to price in a higher Fed Funds rate as QE1 was essentially over. However, the “Summer of Recovery” didn’t exactly come as planned, and any hopes for Fed tightening disappeared and the 2-year rallied hard.

The ten-year’s move over the same period was more smoothed out. In contrast to the 2-year, longer term rates are more influenced by inflation expectations than fed policy, so on a relative basis they were less volatile than the short-end in the early part of this year.

As opposed to the move higher in rates late last year, the most recent move has a much less to do with the Fed. The two year is up 26 basis points from the low in November, but at .6% is still far from the 1.14% at the end of last year. This year’s move has been exaggerated in the long end with the ten-year up almost 100 basis points over roughly the same period.

Why? Well, unlike last year, the market seems much more interested in pricing in greater inflation than tightening, and for good reason. Commodities, as measured by the CRB index is up 31% over the last 6-months, the Fed has explicitly said that they will concentrate on targeting higher asset prices and waiting for a turnaround in lagging indicators like the unemployment rate before they tighten. Implied probabilities are still projecting just a 25% chance that the Fed will raise to .5% by the November 2, 2011 meeting, which is keeping the short-end very low and the curve as a whole very steep.

In the New Year the market will be focused on whether the bond market has it right this time around, or if this was just another late year false signal.

Have a great weekend. 

Cliff J. Reynolds Jr., Investment Analyst