By: Levente Mady | Fri, Apr 8, 2005
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First quarter down, 3 to go. While US yields have increased considerably in the 5 year and under sector of the yield curve - as much as 70 basis points in 2s and 3s, 10 year yields were only 26 basis points higher, while the long bond yield actually declined 7 basis points during the first 3 months of the year. As a result, one main theme of the past quarter was a substantial flattening of the yield curve. The Canadian bond market was a similar story but to a lesser extent. The other main theme, especially during the past month, has been the wider corporate spreads. While various commentators have pointed out that the yield curve has been in a flattening mode for the better part of over a year, we are just now getting back to long-term (25 year) averages in terms of the shape of the curve. There is loads of room for further flattening. As far as corporate spreads are concerned, overall, they are still tight by historic standards. Auto paper on the other hand is cheap. The problem here is that it could get even cheaper and run into liquidity problems due to the abundant supply.

NOTEWORTHY: Last week had a full slate of economic releases again. Not only did the employment report disappoint, but also Weekly Jobless Claims appear to have turned the corner and this series has turned higher in the past few weeks. At the same time, Consumer Confidence has been deteriorating with a high degree of correlation across a number of surveys. The housing market appears to be still moving up. The question on this front is not "if", but "when" it will start folding. Higher interest rates and higher energy prices coupled with negative real income growth are having a negative impact on spending and once the mirage of rising house prices disappears, consumers will be hard pressed to find additional cash to spend. And just in case anyone forgot, the consumer is 2/3 of the economy. This week will be quiet on the economic data front.

INFLUENCES: Fixed income portfolio managers have moved to a somewhat less bearish stance over the past few weeks. (RT survey was unchanged at 42% bullish. This metric is somewhat bullish from a contrarian perspective.) The JPMorgan Fixed Income Manager survey also showed an increase of bullish sentiment from a low of 0 to 11% during the past few weeks. While this number is still bearish from a contrarian perspective, it is not nearly as extreme as the recent zero value was. Specs are short 214k T-note contracts (versus a short position of 219k last week), which is outright bullish. The 'smart money' commercials are still long 525k contracts (slightly off from last week's record 576k). The Commitment of Traders data is still off the charts bullish. I believe it was one of the main factors that provided solid support for the market last week, I am surprised that it is still so extreme, and should provide ongoing support. Market seasonals are somewhat positive for a couple of weeks before turning negative again in the second week in April. On the technical front, charts are telling us that US 10 year notes are establishing a new trading range between 4.40% and 4.70%.

RATES: US Long Bond futures closed at 111-25, up $1 and 20/32 on the week, while the yield on the US 10 year bond decreased 14 bps to 4.45%, after briefly trading through resistance at 4.42% in reaction to the friendly Payroll release on Friday. I am staying neutral and expect bonds to be stuck in the trading range mentioned above for the next week or two. 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 76 basis points through Dec05 EuroDollar futures, which was practically unchanged from last week's close again. While the Bank of Canada has joined the Fed with a hawkish rhetoric, I don't imagine they will be in a hurry to raise rates as long as the Canadian Dollar stays above 80 cents. 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 2 wider at 117, while long Ontario bonds were out 1 to 51. A starter short in TRAPs was recommended at 102 back in February 2004. In auto-paper land, it was Chrysler's turn to get whacked last week. As I previously mentioned: there is never just one cockroach. Rumour has it that some hedge funds involved in the junk bond space have been struggling somewhat lately. Shorter maturity, quality corporates should be favoured over lower rated issues as I believe corporate spreads will continue to be under pressure. Any credit that is connected with the consumer and discretionary spending should be avoided.

BOTTOM LINE: Neutral continues to be the operative word on bonds. 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. This trade has worked quite well for the first quarter as it has narrowed somewhat as well as provided around 50 basis points of extra carry for the quarter. Short exposure for the corporate sector was advised since February 2004. This sector is expected to move substantially wider going forward. 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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