By Isobel Kennedy

NEW YORK, Dec 10 (MNI) – As the Treasury market began its long wait for the
Federal Reserve’s decision later this week, it was the European markets that
inspired the price action.

The 10-year note hit a low yield of 1.597% late in London time and it was
not until late in the New York morning that the yield snugged back up to
1.627%.

A series of stories from the European markets inspired the market bid and
below is a brief description of each item:

1) German government bonds were bid higher Monday, taking Treasurys with
them, as periphery bond yield spreads widened in the wake of the weekend
decision by Italian Prime Minister Mario Monti to resign once the 2013 budget
has been passed in parliament. Monti’s announcement ended days of speculation
about a possible government crisis and snap elections and comes two days after
former PM Silvio Berlusconi’s People of Liberty party withdrew its support. S&P
on Friday warned that Italy’s economy could continue to contract in the second
half of 2013, citing political uncertainty as one of the factors;

2) The markets worried about the delay if Athens decides to re-open the
debt-buyback book for 1-2 days. Greece has bids for over E27 billion but is
short their target of E30 billion;

3) The European Commission, the European Central Bank and the
International Monetary Fund want to make the creditors and shareholders of
Cyprus’ troubled banks contribute to the planned rescue measures, German weekly
Der Spiegel reported over the weekend, citing a draft of a memorandum of
understanding between the troika and the Cypriot government. According to the
magazine, the MoU stipulates that “bank owners and creditors with subordinate
claims must take losses before public aid is granted;”

4) Ireland needs more time to repay central bank emergency assistance,
ECB Governing Council member Patrick Honohan said in an interview with German
daily Frankfurter Allgemeine published over the weekend. The repayments, due in
annual installments of E3.1 bln over a 10-year period, come “at the wrong point
in time” and make it difficult for the country to issue bonds as it did before
the crisis, the central bank governor said. Therefore, he urged that the
repayment period be “significantly lengthened.”

As one funny American source said, “if you want bad news, Europe is always
happy to oblige!”

The focus on Europe mingles with the nagging uncertainty over the U.S.
fiscal cliff. Many think a deal will not be reached until very late this year if
at all. That is also keeping Treasurys very well bid.

There have been some opinions lately that even if the U.S. goes over the
fiscal cliff it will likely be only for a few days in early January so no damage
will be done.

It is unlikely that the financial markets will be that sanguine about the
prospects. Right now the markets are contained because they still have faith
that a deal can be reached. If their faith is shattered, get out of the way.

Ian Lyngen, strategist at CRT Group, wrote in the daily piece Monday, “The
political saga continues to unfold and we’ll continue to watch incoming
headlines as the looming deadlines nears, but as we’ve emphasized a number of
times in the past, we ultimately expect no solution to be released until the
last possible moment. What are you doing New Year’s Eve?”

On Wednesday the Fed will announce what it plans to do with the expiring
Operation Twist Program in which the Fed sells short-dated Treasurys and buys
about $45 billion longer-dated Treasurys each month.

Deutsche Bank strategists think the Fed will likely “keep it simple” by
suspending Twist sales and keeping the same amount of Treasury buying — thus
raising the “duration takeout from around $53B to $63B per month.”

This could surprise the markets, Deutsche Bank thinks, and 10-year yields
could fall about 12 bps to 1.50%.

If this occurs, the strategists suggest selling the market because they
expect a “cliff band aid” before the end of the year.

The agency mortgage-backed securities market would probably not like this
scenario either because its customers are already balking at record high dollar
prices.

Conversely, Deutsche Bank thinks if the Fed follows St. Louis Fed President
James Bullard’s suggestion of reducing the notional amount of Treasury buys to
$25 billion per month, it would reduce the duration take out to about $35
billion per month.

This could upset the Treasury market and rates could rise 20 bps, Deutsche
Bank says.

This is a scenario, however, the mortgage market might like.

Economists at Bank of America Merrill Lynch said in a research report last
Friday they “continue to expect the FOMC to announce outright purchases of $45bn
in Treasuries (to replace OpTwist) and $40bn in MBS, in an open-ended program.
We anticipate purchases will continue at a similar pace through most of 2014,
adding nearly $2tr to the Fed’s balance sheet.”

The economists think this will take place even if the economy improves.

NOTE: Talk From the Trenches is a daily compendium of chatter from Treasury
trading rooms, as well as some sister market trading rooms, and is offered as a
gauge of the mood in the financial markets. It is not necessarily hard, verified
news.

–MNI New York Bureau; tel: +1 212-669-6434; email: ikennedy@mni-news.com

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