BondWorks

By: Levente Mady | Wed, Mar 16, 2005
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The bond market got killed again this past week. As per last week's comment, the market's inability to trade back down through 4.30% on the 10 year yield leaves us no choice but to move to a neutral position. At this point the price action - while oversold - is quite negative. The seasonal influences also contributed to the pressure. The better than average results in last week's 5 and 10 year auctions did not seem to generate anything but a fleeting moment of support for the market. Trading volumes have been huge over the past few weeks, confirming the downward bias. The overwhelming bearish positioning and sentiment holds me back from joining the bear camp, but staying long obviously has not been a winning strategy. The fundamental picture has not changed. Rising yields, a tightening Fed and $55 oil are not ingredients that will keep the consumer humming along. But for now, according to consensus forecast, the economy is bullet-proof and will stay that way in the foreseeable future. Stay tuned to see how long this will last.

NOTEWORTHY: Last week was fairly quiet on the data front. The US Trade Deficit was predictably reported above expectations again. Consumer Confidence, while still negative, rose with the stock market. Canadian employment rose 26.6k last month, but it was mostly government jobs that boosted payrolls. Government is good! Next week is filled with more consumer data - in the form of Retail Sales, Housing Starts and more Survey results -, as well as manufacturing surveys and Industrial Production data. While there will be a number of releases, most of them will be minor in nature. The chatter about the plans for Central Bank diversification of US$ assets continues to be a favoured topic of the day. In other bond market news, the U.K. and Germany have announced that they will be following in the footsteps of the French Government and will be issuing bonds with 50 year maturity. I wonder how long it will be before the US Treasury will decide to join this dance. The bond market will be looking forward to the FOMC meeting on March 22, which will be all about semantics, as another 25 basis point hike is a done deal.

INFLUENCES: Fixed income portfolio managers are more bearish and selling into weakness. (RT survey was down another 1 point to 38% bullish. This metric is quite bullish from a contrarian perspective.) The incredible thing during this sell-off is that real money accounts have sold into this weakness, so durations have become even shorter than they have been in the past year plus. The market is giving all the longtime suffering shorts a glorious chance to cover and they are doing just the opposite. Specs are short 110k T-note contracts (versus a short position of 20k last week), which is supportive. The ‘smart money' commercials are long 450k contracts (up from last week's near-record 309k). This figure is definitely a record. The Commitment of Traders data is unequivocally bullish. Market seasonals continue to be negative going forward. As mentioned above, the short term charts are extremely negative.

RATES: US Long Bond futures closed at 110-20, down almost two and a half on the week, while the yield on the US 10 year bond was up 23 bps to 4.54%. Further weakness and a break through 4.42% changed my outlook to neutral. Next support is at 110-00 on the Long Bond Futures. Trading through 4.64% could open the door for 4.75% or higher on 10 year yields. The 4.42% level is still key resistance on the path to lower yields. The Canada - US 10 year spread was 7 wider at -13 basis points. We are officially neutral on this spread at this point. Dec05 BA futures closed the week 90 basis points through Dec05 EuroDollar futures, which was out another 5 basis points from last week's close. At 62 it was an official trade recommendation to buy EDZ5 to sell BAZ5. The belly of the Canadian curve underperformed last week, and is becoming cheaper yet. 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 57 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 stable last week. Long TransCanada Pipeline bonds were unchanged at 108, while long Ontario bonds were in 0.5 to 47.5. 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 moved to neutral on bonds once it became apparent that the 4.3% level will not be breached. The move through 4.42% confirmed a move to higher yields. Look for the choppy, volatile action to continue this week. I still recommend for shorts to cover, or at least pare back their positions and get closer to neutral. 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.


 

Levente Mady

Author: Levente Mady

Levente Mady,
Institutional Advisors

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