Raise your hand if you’ve been waiting, and waiting, and waiting for interest rates to finally rise.  No way rates could stay at zero forever we said in 2010, and again in ’11, and ’12… and then finally in ’13 – a light at the end of the tunnel. Rates actually went up as bonds lost –4.54% ($BND).  2014 was surely the year the move lower (rates higher) was going to gain steam, fueled by more tapering and perhaps turning into the mother of all trend following trades. The time was now.

Except… nobody remembered to tell the bond market what it was supposed to do this year; and before you knew what was happening – the long end of the curve has rallied (prices up, rates down) with the yield on the 30 yr falling from 3.90% to 3.40% so far this year.

(Disclaimer: Past performance is not necessarily indicative of future results)
Data Courtesy: Quandl

What is going on?  Why are bonds rallying at the same time we’re tapering, at the same time the Dow is making new all time highs?  Is it the Russell 2000 and tech stock meltdown? Is it the Russian/Ukraine conflict?  Or is it something else altogether. Bloomberg explains that there may be a supply problem in both the 10yr and 30yr markets.

“Excluding those held by the Federal Reserve, Treasuries due in 10 years or more account for just 5 percent of the $12.1 trillion market for U.S. debt.”

Fewer available bonds, along with a lack of inflation and increased foreign buying, help to explain why longer-term Treasuries are surging this year even as the Fed pares its own bond purchases. The demand has pushed downyields on 30-year government debt by more than a half-percentage point to 3.37 percent, the most since 2000, data compiled by Bloomberg show.”

What? Supply in bond futures.  That isn’t something you hear of every day. This isn’t Soybeans or Corn where supply is a main ingredient of price discovery, where traders pore over crop reports trying to see how big the harvest will be in order to figure their positions. But bond futures do have a bit of a history when it comes to supply issues. A little firm named Pimco got in the supply weeds back in 2005 when they suddenly owned more 45% of the deliverable for the 10yr Note futures market, via the New York Times (yes this is a NYT article from 2005).

“Problems began emerging in late May, when traders who had sold the 10-year note short suddenly found that they could no longer go into the open market and borrow the securities for delivery to their purchasers. If sellers of a security cannot deliver it to buyers, the trades cannot settle. In Wall Street parlance, this is called a “fail.”

ACCORDING to traders, beginning in late May and extending into June, billions of dollars of the 10-year Treasury were failing each day. It was clear that one or more holders of the securities had stopped lending them, setting up what appeared to be a perfect short squeeze. As sellers scrambled to buy back the securities to cover their short positions, the price of the Treasury rose, creating losses for anyone who still had a short position.

The June turmoil was not limited to the Treasury market, however. It also created problems for the throngs of traders at brokerage firms, hedge funds and banks that use the futures market to hedge their positions in other fixed-income securities. At one point, positions taken by investors in the Treasury futures contract that had the unborrowable 10-year note as its underlying security reached $200 billion.”

It took until 2010 to settle the ordeal, and Pimco ended up settling to pay $92 Million for allegedly manipulating the market; but maybe those days aren’t over. We doubt Pimco would wade back in those waters – but somebody might be brave enough to try it.