I must admit that this is the second time in a row that I missed a short term trading opportunity and it irritates me that I did not learn my lesson from last time. The technical indicators were as overbought as I have seen them in a long time when 10 years traded down to 4% at the beginning of February and I should have moved at least to neutral in my market view, if not then, at least when yields failed and started moving up afterwards. But hindsight is 20-20, and I was too busy being a contrarian and not keeping my eye on the price action. With the big bucks I get paid for writing this commentary, I should never ever let that happen. Last week's market action was opposite of the rally I expected early in the week, followed by weakness following stronger than expected payroll data. The part that I got right was the stronger than expected payroll data and continuing weakness on the ISM Manufacturing survey. The 4.30% resistance was convincingly broken on huge volume as early as Monday and the shorts were set in droves by the time Payrolls were released on Friday. The whisper numbers on Payrolls were well north of 300k, so even with the number coming in over 50k (with revisions) better than consensus, bonds finished up a dollar on Friday.
10 year yields have been trapped in a 4.4-4% range since last August. During the same time span short rates have been trending up with the Fed on the warpath, while the long end is trading at 4.65% which equals the lowest yield it traded at for the entire 2004 calendar year. Also, Canadian 30 year yields have been in a rock solid down-trend, every single pull-back to the 50 day moving average has held. This time was no different. My positive bias for bonds was lukewarm last week. After last week's action, my bullish conviction for the long end has been restored to a solid state.
NOTEWORTHY: While some indicators - such as housing data and the headline payroll number - tell us that the economy continues to expand at a healthy clip, all is not well in the good old US of A. Auto sales were a disaster for the second month in a row. Sentiment surveys are losing altitude on both the manufacturing and consumer front. The only positive item on the employment data was the payroll figure. The headline rate rose from 5.2 to 5.4% even though the Participation Rate is at rock bottom and still declining. Hourly earnings were flat, and so was the work week. Meanwhile the inflation data is benign as prices paid are falling, labour costs are not keeping up with inflation and pricing power is non-existent at the consumer level even with oil trading at $54/barrel. Next week will be quiet on the economic front until Friday's Trade Balance data release.
INFLUENCES: Fixed income portfolio managers are more bearish. (RT survey was back down another 1 point to 39% bullish. This metric is quite bullish from a contrarian perspective.) Specs are short again, mind you only 20k T-note contracts (versus a long position of 87k last week), which is neutral. The 'smart money' commercials are still long a bullish 309k contracts (nearly double last week's 157k). This figure must be close to a record. The Commitment of Traders data is unequivocally bullish. Bonds held key resistance at 4.75%, while 10s bounced from 4.42%, the long term trend is still positive. Market seasonals are negative going forward.
RATES: US Long Bond futures closed at 112-31 (we switched to the June contract), down a quarter on the week, while the yield on the US 10 year bond was up 4 bp to 4.31%. During the week we hit a high yield of 4.42% before bouncing back on Friday. My bias remains positive. 10 years are trading at a key level near 4.30%. I believe that we are heading to lower yields in the long end, but I need to see 10s trade through 4.3% to confirm my outlook. Further weakness and a break through 4.42% would change my outlook to neutral. The Canada - US 10 year spread was 4 wider at -6 basis points. We are officially neutral on this spread at this point. Dec05 BA futures closed the week 85 basis points through Dec05 EuroDollar futures, which was out another 4 basis points from last week's close. At 62 it was an official trade recommendation to buy EDZ5 to sell BAZ5. A weakening Canadian dollar should provide support for this spread to narrow. The belly of the Canadian curve was stable in spite of market weakness last week, but the belly is still cheap. Selling Canada 3.25% 12/2006 and Canada 5.75% 6/2033 to buy Canada 5.25% 6/2012 was at a pick-up of 54 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 (including roll-down) for the Canada bond maturing in 2011 is the best value on the curve. In the long end, the Canada 8% bonds maturing on June 1, 2023 continue to look like very good value.
CORPORATES: Corporate bond spreads were well bid last week. Long TransCanada Pipeline bonds were 2 bps narrower to 108, while long Ontario bonds were in 1 to 48.0. A starter short in TRAPs was recommended at 102 back in February 2004. Credit spreads are still excessively tight; there is loads of room to the wider side. Quality corporates should be favoured over lower rated issues.
BOTTOM LINE: I remain positive on bonds. An overweight position in the belly of the curve is still recommended for Canadian accounts. Short exposure for the corporate sector was advised since February 2004. Sell BAZ5 to buy EDZ5 at a pick-up of 62 bps or better was recommended a few weeks back.