By: Levente Mady | Thu, Jan 6, 2005
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Well, now that the holidays are over, it is time to buckle down and start the fresh New Year on the right foot. I am sure you all had your fill of predictions along with your fill of turkey, ham and other yummies during the holidays. So I will not bore you with a massive, comprehensive forecast for 2005, I will just stick with what seemed to work in 2004: what is driving the bond market and where the opportunities are to make some money in the next week to next month. Beyond that, I will leave the crystal ball gazing to such luminaries as Byron Wien - who is forecasting 6% 10-year Treasury yields and an unchanged stock market, and Abby-postergirl-for-Prozac-Joseph-Cohen - who is as cheerful and bullish as she has ever been.

NOTEWORTHY: The economic data was mixed to positive over the holidays. The data on the employment front was on the weak side, as the Help Wanted index continues to be stuck at multi-year lows, while the employment component of the ISM Survey has been crashing distressingly. Data in the housing market and construction has been sending mixed signals, while the consumer has been surprising to the upside both in terms of sentiment and spending driven by bargain hunting. This week's highlight will be the payroll data, which I expect to come below the 175k consensus. This is the number that matters the most and will be setting the tone for the bond market for the weeks to come.

INFLUENCES: Fixed income portfolio managers are somewhat less bearish last week (RT survey steady at 41% bullish, up 3 points from the lowest level in 15 years set just prior to year end). I need to see this number closer to 50% to turn negative on bonds. Specs holding their long position steady at a somewhat negative +47k. While on the sentiment topic, I just can't resist mentioning that 55 out of 56 economists participating in a WSJ panel predicted higher 10 year yields for 2005 - with the average at 4.80%. If that is not bullish for bonds, then I am not quite sure what is.... Bonds are trading sideways and the longer-term chart remains constructive. Seasonals are neutral and will be deteriorating going forward. Bond market seasonals are most negative all year from late January through early May.

RATES: US Long Bond futures closed the year at 112-16, pretty much unchanged over the holidays, while the yield on the US 10 year bond rose 1 basis points to 4.21% after trading as high as 4.35%. As mentioned above, a weaker than expected payroll number will set a positive tone for the rest of January. The Canada - US 10 year spread closed the year moving in 5 to 7 basis points. Buying Canadian 10 year bonds to sell US 10 year notes and pick up 50 basis points was recommended in late September and taking profits was recommended 2 weeks ago when the spread was trading in single digits. While the bulk of this move has already transpired, I still believe Canadian bonds are on the cheap side relative to the US 10 year bonds. The front end in the US was heavier than Canada last week. Dec05 BA futures closed the week 49 basis points through Dec05 EuroDollar futures, which was 3 basis points wider than last week's close. It makes sense to sell BAZ5 to buy EDZ5 north of 40. The belly of the Canadian curve was stable to the wings last week, but the belly is still cheap. Selling Canada 3% 12/2005 and Canada 5.75% 6/2033 to buy Canada 6% 6/2011 is 3 wider at a pick-up of 63 basis points. As the curve continues to flatten, the belly should continue to outperform. Assuming an unchanged curve, considering a 3-month time horizon, the total return for the Canada bond maturing in 2012 is the best value on the curve.

CORPORATES: Corporate bond spreads were well supported last week. The buy side is way long this sector. Long TransCanada Pipeline bonds finished the year at 110, while long Ontario bonds were at 45.0. A starter short in TRAPs was recommended at 102 back in February. Credit spreads are excessively tight and the appetite for risk in the bond market seems to be insatiable at this point. There are a number of good reasons for this, but I believe that it will not go on indefinitely.

BOTTOM LINE: We are at the crossroads here. Today (Tuesday) we had the reverse-liquidity trade transpire with some force. The US Buck was strong, while pretty much everything else - including stocks, bonds, commodities, etc. - was weak. Copper (the metal with the Ph.D. in economics) was down over 10% at one point today. Just the opposite of what has transpired over the past 2 years. The 2-10 curve in the US has flattened from 274 to 109 in the past 15 months. The carry trade is disappearing fast. Nothing is cheap here according to Marc Faber. I can't disagree with him. Tobin's Q is over 2 for the 3rd time in the past century (the other times were 2000 and 1929). If this reverse liquidity trade gains traction, bonds could get hurt with everything else in the process. However, they will get hurt a lot less than commodities, junk bonds, beta stocks, and the like. On the other hand, especially with ongoing pessimism still pervasive in the bond sector, we could be heading into an early-90s-Japan-like bond friendly scenario. I remain positive on bonds. With an ongoing slowdown not properly priced, I believe the front end is cheap in the US. An overweight position in the belly of the curve is still recommended. Short exposure for the corporate sector was advised since February. I was way too early on this one, but I am convinced corporate bonds are stinking expensive. Long Canada - Short US 10 year position was established at +50. It is recommended that this position be covered on strength to even yield.


Levente Mady

Author: Levente Mady

Levente Mady,
Institutional Advisors

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