RATES: While bonds took a pretty good beating, I continue to maintain that there is still plenty of slack in the economy for inflation to stay on a declining trend. However there are 3 other issues that temper my bullish enthusiasm for the bond market at this juncture. First one is a deteriorating technical backdrop (mind you a weekly outside reversal to the downside did not seem to bother the Dow Transports enough to stop them from setting a new multi-year high the very week following that reversal). My second concern is the good old US Dollar. While I fully realize that on a purely fundamental basis the dollar should be getting annihilated, due to the generosity of the various foreign investors that were willing fund the various deficits that the USA is boldly taking into uncharted territory, the Dollar Index has traded mostly sideways for the better part of this year. Now the US buck is trading at critical support. Should the dollar break down here, I doubt if US stocks and bonds will embark on a rally similar to what we saw last time the dollar lost in excess of 25% of its index value. And last but not least, specs are getting into heavy long positions at this point. With another critical set of employment data set to be released on Friday, I just don't see a big reward to justify taking a position of consequence heading into those numbers.
No big surprises on the economic front last week. While the construction sector is getting a second wind from lower rates, and second quarter GDP was revised up .5%, inflation and consumer sentiment data reported last week came in below expectations again. In Canada, GDP expanded at the "astronomical" rate of 0.1%, and the Canadian dollar appreciated another penny to cause yields to back up across the yield curve as if this type of data should continue to motivate the Bank of Canada to fight the windmills of inflation. Next Friday is Employment Report Day in both the US and Canada. All those bullish economists out there are looking for an anemic 150k growth on payrolls, which would not be sufficient to keep inflation from falling or the output gap from rising.
Fixed income portfolio managers slightly less bearish last week (RT survey up 2 points to 41% bullish). Specs are now long 75k contracts in the 10-year Note futures. This is a level that is definitively bearish. Bonds put in an outside reversal week down on the charts, while short-term momentum measures topped out and are fading. Seasonals are excellent for another week, but positive effects did not materialize last week, so it will be interesting to see if the most positive seasonal period of the year in bonds will go missing entirely this year. The expected month- and quarter-end term-extenders were missing in action or perhaps over-powered by massive selling from other sources.
US Long Bond futures closed at 111-15, down $2 last week, while the yield on the US 10 year bond increased 16 basis points to 4.19%. While the short-term picture has deteriorated considerably, long-term fundamentals still argue for a favourable environment for bonds. Obviously the payroll data will set the tone in the short term. Canada - US 10 year spread closed at 48, in 5 on the week. Canada is cheap to the US, buying Canadian 10 year bonds to sell US 10 year notes and pick up 50 basis points was recommended a few weeks ago. The March05 BA futures position I bought at 97 closed at 96.93, down 3 cents this past week. The belly of the Canadian curve under-performed by 3 basis points versus the wings last week, but it is still cheap to the wings. As the curve continues to flatten, the belly should continue to outperform. Overweight the belly is still the best trade idea I have. Assuming an unchanged curve, considering a 3-month time horizon, the total return for the Canada bond maturing in 2011 is the best risk weighted value on the curve.
CORPORATES: Corporate bond spreads were stable again last week. The buy side is way long this sector. Long TransCanada Pipeline bonds unchanged at 118, while long Ontario bonds were out .5 to 46.5. A starter short in TRAPs was recommended at 102 back in February. I fully agree with Bob Hoye's concerns regarding the ABS market and wish to stay clear of that sector.
BOTTOM LINE: I still like bonds on a longer term, fundamental basis. However, there are a number of short-term negatives (outlined above) that take me to neutral in the short run. A sudden break below 87 on the Dollar Index would push me to the bear camp. An overweight position in the belly of the curve should have been pared from 100 to 75%. In other words, 2010-2012 maturities are still heavily favoured. Short exposure for the corporate sector was advised since February. A long position was established in the March05 BAX futures under 97. Long Canada - Short US 10 year position was established at +50.
GENERAL COMMENTS: - One debate down (2 to go), and Kerry moves from 8 points down to 2 ahead; this could get very ugly for the Bush camp.... - M3 was up $44.1B last week after trending flat to down for the past 3 months.... - Famous BMO Harris Bank strategist recommends extending bond duration from super short to very long - more bearish news for bonds...