Tuesday, October 10, 2006

What now?

I had been arguing that the Treasury market had rallied too far too fast for several weeks now. I can't say "I was right" quite yet, because at the time I wrote that, the 2 year was above 4.90%. We have, however, backed up about 20bps on 10's and nearly 25bps on 2's since Wednesday.

So at what point do I retract my "too far too fast" claim? I took another look at the Fed path analysis which I have done in the past. It looks like the median path is still for a rate cut around February 2007, and then two more over the next 18 months. Is that reasonable?

Well, reading all the Fed speeches over the last 3 weeks, I say not quite. The most reasonable scenario is for no more than 1-2 cuts over the next 12-months, with the first coming at least 6-months out. That makes your best case scenario with the 2 and 5-year about 5bps higher. If its only 1-cut, that implies a 25bps sell-off. If its no cuts, I think we sell off 40bps.

So I'd say the risk/reward starts to turn against a short position someplace around 2yr=5.00%, 5yr=5.05%, and 10yr=5.10%. Obviously new data could change my mind.

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