[A-List] Interest-rates and short squeezes

[Hudsonmi@xxxxxxx]

    I hope you guys aren't missing the big story these days about the growing conflict within the finance-capital sector - Morgan Stanley Dean Witter, Goldman Sachs, Merrill Lynch, etc.
    The story concerns the course of interest rates, and hence, bond prices. Last week Morgan Stanley reported sharply lower earnings as a result of bad guesses on the course of interest rates, leading to options and derivatives trade in Treasury-bond futures.
    Much of Wall Street saw that the Fed intended to raise short-term interest rates, and concluded that long-term rates would also rise. This meant that prices for existing bonds would decline. Investors sold hundreds of billions of dollars of Treasury bonds short - that is, they promised to deliver them at a later date at a pre-agreed price, expecting to be able to buy these bonds at a lower price as interest rates rose.
    But long-term rates did not rise. Short-term rates rose, but there was an immense demand for 10-year Treasury bonds. The upshot was a "short squeeze": Buyers bought bonds because they knew that as prices rose, the short sellers would have to buy bonds to cover their positions (that is, their promises to buy and deliver these 10-year Treasury bonds). The larger the short-sale volume grew, the more demand was scheduled to come into the bond market, bidding up prices. (A similar price rise occurred in 1994.)
    The upshot was something like George Soros's raid on Britain's attempt to stabilize sterling. It all became a question of who could raise more money: buyers or sellers.
    Yields yesterday on 10-year Treasury bonds fell below 4%, despite the fact that the Fed raised short-term rates earlier this week.
    Meanwhile, the Financial Times speculates on whether lower long-term Treasury rates will lead mortgage rates to decline, prompting re-financing. If this occurs, FNMA and GNMA will receive lower payments, but have to pay out high payments to THEIR bond-holders.
    Looks interesting.

Michael