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ANALYSIS-US bond market strewn with landmines

By Daniel Sternoff NEW YORK, Feb. 4 (Reuters) - The U.S. Treasury market may hold nasty surprises for weeks to come as market players wrestle with the implications of an unprecedented squeeze in the supply of debt by a government fat with budget surpluses.

Massive movements in bond prices in recent days will require bond investors and dealers to embark on a perilous round of position adjustment in a bond landscape that few, if any, have ever witnessed.

"There is no mental exercise you can go through to say whether the shake-up is done or not without knowing everybody's positions," said Patrick Dimick, fixed-income strategist at Warburg Dillon Read LLC.

"There is no historical precedent for a (Treasury) paydown scheme and the elimination of issuance such as the one we're about to go through," he said.

For the last week bond markets have been stung by extreme volatility. By many accounts, major financial institutions suffered painful losses as the market churned and dealers digested the U.S. Treasury Department's plan to buy back some $30 billion in government debt this year and reduce issuance of longer-dated paper.

"The market right now is like a wounded animal. You don't know if it is going to come after you or run away," said Ward McCarthy, managing director at Stone and McCarthy Research Associates.

T-BOND: FROM BENCHMARK TO COLLECTORS' ITEM

The Treasury's plan, announced earlier last month and detailed this week, roiled a market that had been shorting bonds -- betting prices would fall and interest rates rise -- as breakneck economic growth eventually generated inflation.

McCarthy said that as of January 5, dealers were short an aggregate $32.9 billion in U.S. Treasuries -- the shortest the market had been in two years.

At the same time, major institutional bond funds were underweight Treasuries, betting that the difference between yields on government bonds and higher-yielding debt such as corporate and agency paper would narrow over time, he said.

But many of those bets went sour on an astonishing scale as the Treasury's buyback plan gave long bonds a scarcity value overnight. "They're like a depletable commodity," McCarthy said. Long-term bonds rocketed higher, sending long-term interest rates dropping below those of short-term notes in an inversion of the Treasury yield curve. Longer debt usually yields more to pay investors for long-term inflation risks.

The run-up in prices triggered waves of short-covering that shaved half a percentage point off the T-bond's yield in two weeks. At one point Thursday, the 30-year bond soared a mind-boggling three points higher to yield 6.14 percent versus 6.75 percent on January 18.

"It is probable that some pretty big players had their tonsils ripped out," McCarthy said.

Though rumors have been rife of big bond losses, major firms with sizable bond businesses, such as Goldman Sachs Group Inc and Lehman Bros Holdings Inc., declined comment. Others dismissed such talk.

"It's hard to imagine that any firm lost more than $20 million or $25 million on a 25-basis-point move in the bond," said Charles Parkhurst, managing director of government trading at Salomon Smith Barney.

MORE SHORTS TO SQUEEZE?

A measure of normalcy returned to the Treasury market on Friday, when prices fell after a stronger-than-expected U.S. jobs report reawakened inflation concerns.

But few strategists are willing to wager the market has shaken out all its shorts.

Warburg's Dimick said it was fair to assume there were more shorts still in the market, given the relative ease with which investors on futures markets could place leveraged bets, or use borrowed securities to boost the size of their wagers.

Holly Liss, vice president at Fuji Futures Inc. in Chicago, said Friday's pullback -- the long bond dropped as much as two full points in the morning -- had some traders believing Thursday's gains marked a peak before prices fell again.

"People are not only still short, they are comfortable at shorts and putting more on," Liss said.

She, however, believed the market was merely consolidating before moving higher -- which could spark more volatility.

"If we have people getting short again and we start heading up a few ticks, people will start bailing out and that accelerates the upmove," Liss said.

WHEN IN DOUBT, KEEP OUT

Dimick said while uncertainty would reign for some time to come, modern risk management techniques meant investors would likely adjust their positions within a matter of weeks.

"The way profit and loss accounts are marked to market these days, my instinct tells me the adjustment process has to be done within a couple of weeks," Dimick said.

Meanwhile, he suggested the following strategy: "Don't trade."

ANALYSIS-US bond market strewn with landmines

We havn't heard the last of this situation yet.



-- Farouk Madjurian (fmadjurian@hotmail.com), February 04, 2000

Answers

1) Hmmm.sounds like I should stay with my 401K in bonds and money market for the moment. It might yield some interesting surprises!

2) And I thought bonds were a boring investment!

-- Mad Monk (madmonk@hawaiian.net), February 04, 2000.

Common sense whispers that more ugly surprises are soon to be revealed...

-- dinosaur (dinosaur@williams-net.com), February 04, 2000.

An interesting commentary. Thanks for posting it Farouk.

Jerry

-- Jerry B (skeptic76@erols.com), February 04, 2000.