BondWorks

By: Levente Mady | Wed, Apr 13, 2005
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Let's take a brief look at the big picture. While the Chinese and Indian economies are screaming ahead with double digit growth, major European and other Asian countries are barely growing. However, as it has been for the better part of the past 15 years, the US economy holds the key to world prosperity. Over the past 3 years the US had a strange post-bubble recovery. This was driven by an unprecedented increase in liquidity as tax cuts and record low interest rates spurred consumer spending. It did not matter much if short term rates in Brazil were 15 or 20%, or if the Bank of Canada was holding rates steady. What mattered most was that the overnight lending rate (a.k.a. the Fed Funds rate) in the world's most liquid market in the world's reserve currency was 1%. Barring a major accident, the Fed Funds rate should hit 3% 3 weeks from this coming Tuesday. That is a cool 200% increase from the 1% rate of last summer. Experts are arguing that this level is still accommodative - try telling that to the good folks who are paying interest-only Adjustable Rate Mortgages. The fact is that while interest rates that matter the most are rising, there are no further tax cuts to ease the rate hike bite, so liquidity is drying up at a measured pace. Meanwhile the P/E ratio of the Nasdaq is at 38.44 as of this morning, credit spreads are under pressure, and consensus is looking for ongoing strong growth.

NOTEWORTHY: Last week was quiet on the economic front. The main data point worthy of note was the Weekly ABC Consumer Confidence dropping another 4 points to -17. This metric has declined 10 points since the beginning of March and the chart does not look healthy. In spite of easy money, increased leverage and a resulting ongoing spending binge, this metric shows just how fragile the consumer is at this point. In spite of a "healthy recovery", Consumer Confidence as measured by this survey did not recover anywhere near to levels seen at the turn of the millennium. I expect Consumer surveys to continue to deteriorate as previously discussed here. This week will be quiet on the economic data front; the Trade Data, Retail Sales and the ongoing weekly surveys are not expected to have much of an impact on interest rates.

INFLUENCES: Fixed income portfolio managers are stuck in a bearish rut over the past few months. (RT survey was down 1 point to 42% bullish. This metric is somewhat bullish from a contrarian perspective.) Specs are short 201k T-note contracts (a slight decline from a short position of 214k last week), which remains outright bullish. The 'smart money' commercials are still long 502k contracts (slightly off from last week's 525k). The Commitment of Traders data is still solidly bullish. I believe it was one of the main factors that again provided solid support for the market last week, and should provide ongoing support. Market seasonals are turning negative again at this time. 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 111-11, down 14/32 on the week, while the yield on the US 10 year note increased 2 bps to 4.47%, after briefly trading through resistance at 4.42% again this week. 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 5 wider to -20 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 14 basis points wider than last week's close. The latest Canadian economic data is pointing to a slower than expected growth profile. While the Bank of Canada has been talking tough, I don't imagine they will be in a hurry to raise rates at their next meeting on Tuesday. At 62 it was an official trade recommendation to buy EDZ5 to sell BAZ5. The belly of the Canadian curve underperformed 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 50 basis points. Assuming an unchanged curve, considering a 3-month time horizon, the total return (including roll-down) for the Canada bond maturing in 2012 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 4 wider at 121, while long Ontario bonds were out 2 to 53. A starter short in TRAPs was recommended at 102 back in February 2004. In auto-paper land, it just keeps getting worse and worse. Last week it was Ford's turn again to lead the way wider as one of the major rating agencies downgraded the company's bonds. As I previously mentioned: there is never just one cockroach. 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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