By: Levente Mady | Wed, Mar 30, 2005
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The FOMC raised another 'measured' 25 basis points for the 7th time in a row. While the higher rates were well advertised, the market seemed to be surprised that the Fed noted an increase in short term inflationary pressures. It is truly remarkable how pretty much the entire economist community is ignoring the fact that liquidity is being drained from the system and what the implications of this action will be on a hyper-leveraged economy going forward. Fed Funds is not only up 175 basis points, it is also up 175%. But who cares, Fed Funds is still considered accommodative as long as it stays below 3... 3.5... 4, maybe 5%. And as long as monetary policy is accommodative, the economy should continue to expand at a 4% (give or take ½%) clip indefinitely. Well, Fed Funds are scheduled to hit 3% in a little over a month from now and I just can't ignore the signal that the flattening yield curve is screaming at me: economic growth will be coming to a screeching halt.

As Dennis Gartman likes to say, there is never just one cockroach. In other words, after the sell-off in GM stock and bonds, it could have been expected that credit spreads in general would come under pressure. We were not disappointed in our expectations. MSD (MS Emerging Market Debt Fund - listed on NYSE) closed at 10.47 on March 10 and proceeded to decline to a low of 8.97, only to bounce back to 9.42 as of Thursday night's close. That is a 15% decline from its March high to its recent low, and a 10% decline on a recent high to latest close basis. During the same time span the 10-day price volatility increased 943% from 4.43 on March 10, to 46.20 the most recent level. We believe corporate spreads will remain under pressure. Caution is advised.

NOTEWORTHY: Last week had a full slate of economic releases. While PPI was sedate, it was the CPI report that held an upside surprise this month. The US housing market continues to defy gravity and just keeps ticking up both in terms of volume and pricing. I am not sure how much is left in this sector, but I reckon the end is near. While housing just keeps going, Mortgage Applications were down close to 10%, Durable Goods Orders were reported below consensus, Jobless Claims have started to tick up and Consumer Confidence ticked down again last week. Another data busy week is coming up, headlined by the monthly Employment Report on Friday. In addition, ISM numbers, GDP, Deflators and other minor data will keep participants entertained.

INFLUENCES: Fixed income portfolio managers have become somewhat less bearish again last week. (RT survey was up 2 points to 42% bullish. This metric is somewhat bullish from a contrarian perspective.) Specs are short 219k T-note contracts (versus a short position of 137k last week), which is outright bullish. The 'smart money' commercials are now long 576k contracts - equal to about 6 months of 10 year Note supply - (way up even from last week's record 509k). The Commitment of Traders data is now off the charts bullish. Market seasonals are somewhat positive for a couple of weeks before turning negative again in early April. On the technical front, charts are telling us to look for a temporary bounce in prices before the next leg down starts.

RATES: US Long Bond futures closed at 110-05, declining 19/32 on the week, while the yield on the US 10 year bond increased 9 bps to 4.59%, after trading as high as 4.69% in reaction to the unfriendly CPI release on Wednesday. I am staying neutral, but would not be surprised to see lower yields during the next week or two. The 4.42% level is still key resistance on the path to lower yields. Support is at 4.65%. The Canada - US 10 year spread was steady at -15 basis points. We are officially neutral on this spread at this point. Dec05 BA futures closed the week 75 basis points through Dec05 EuroDollar futures, which was unchanged last week's close after trading as narrow as 59 basis points at one point. The Bank of Canada has joined the Fed once again with a hawkish rhetoric and this has caused the front end of the Canadian yield curve to sell off. At 62 it was an official trade recommendation to buy EDZ5 to sell BAZ5. The belly of the Canadian curve outperformed the wings by 1 bps last week. 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 49 basis points. 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 way wider again last week. Long TransCanada Pipeline bonds were 3 wider at 115, while long Ontario bonds were out 1 to 50. A starter short in TRAPs was recommended at 102 back in February 2004. Auto-paper has settled down and, if anything, it narrowed somewhat. Rumours of GM selling its mortgage arm and various other businesses have surfaced. If they sell all their money making operations to get some debt relief, is that going to make GM a more worthwhile entity to invest in??? I don't think so. Shorter maturity, 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. 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. This sector is set to start moving wider now. 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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