BondWorks

By: Levente Mady | Thu, Apr 21, 2005
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As expected, it was a quiet week with not much happening on the economic data front. Oil traded down and the experts told us that lower oil prices would help the economy and stocks. On the earnings front, some of the biggies (GE, CitiBank) reported numbers in-line, while some of the techs (Apple) surprised to the upside... Well, so much for the good news. In addition to energy related stocks crumbling, the rest of the stock market decided to join the party. Apple declined close to 25% in the last 2 months. And the bond market actually broke key resistance at 4.42% on the 10 year note and raced to 4.25% in short order. As noted several times in the recent past, consensus is out to lunch in terms of their economic growth expectations. Japan is in a recession, Europe is going nowhere fast, and once the US slows down to a crawl, China, India and the likes will not be far behind. While economists might still be sticking to their rose coloured world view, short term interest rates have rallied over 60 basis points in both the US and Canada in less then a month, drastically re-pricing tightening expectations for the Fed and the Bank of Canada for the rest of the year.

NOTEWORTHY: There were no major economic releases last week. Most of the data that did come out pointed in one direction: slowdown ahead! The Weekly ABC/Washington Post Consumer Confidence dropped another point to -18, a fresh 10 month low. Retail Sales were weaker than expected, Industrial Production was in line. The Empire Manufacturing Index dropped from a healthy 20.2 to a barely positive 3.1 (18.1 was expected). To finish the week off, the University of Michigan Consumer Confidence Index followed the ABC/WP Index and actually outperformed it, setting an 18 month low at 88.7. This week will have inflation data as well as more surveys on the dock. I believe the importance of the CPI and PPI (lagging indicators) has diminished at this point as the market will be searching for more clues of a slowdown. Leading Indicators for March (as opposed to "laggers" such as the inflation data) will also be released on Thursday and surprisingly they are actually expected to decline for the 7th time in the past 10 months.

INFLUENCES: Fixed income portfolio managers are stuck in a bearish rut over the past few months. (RT survey was down 1 point to 41% bullish. This metric is somewhat bullish from a contrarian perspective.) Specs are short 189k T-note contracts (a slight decline from a short position of 201k last week), which remains bullish. The 'smart money' commercials are still long 513k contracts (off from last week's 502k). The Commitment of Traders data is still solidly bullish. Whaddayaknow??? This metric might actually be worth paying some attention to. Seasonals are negative into the second week in May. I suggest disregarding the seasonals at this point. On the technical front, trading through 4.42% on the US 10 year notes and above 113-22 on the June contract of the Long Bond futures have opened the door to higher prices/lower yields in bond land.

RATES: US Long Bond futures closed at 113-18, up 2¼ on the week, while the yield on the US 10 year note dropped 23 bps to 4.24%. I am just happy I was adamant about not shorting the market during the past few weeks. The Canada - US 10 year spread was 12 narrower to -8 basis points. We are officially neutral on this spread at this point, but leaning towards selling Canada to buy US bonds. Dec05 BA futures closed the week 83 basis points through Dec05 EuroDollar futures, which moved in 7 basis points from last week's close. The latest Canadian economic data is pointing to a slower than expected growth profile. The Bank of Canada did not change its benchmark rate last week. However, political upheaval is building in Canada and it would not be surprising to see a new election called before the end of this year. Risk premium for Canada should increase. This should translate into higher rates and a lower currency. At 62 it was an official trade recommendation to buy EDZ5 to sell BAZ5. The belly of the Canadian curve underperformed the wings by 2 bps last week in spite of the rally in bonds. 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 52 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 wider again last week. Long TransCanada Pipeline bonds were 3 wider at 124, while long Ontario bonds were out 1.5 to 54.5. A starter short in TRAPs was recommended at 102 back in February 2004. Auto-paper land still can't find support yet. 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. Corporate spreads have widened considerably, so a pause and perhaps a bounce is due. Look to sell the bounce.

BOTTOM LINE: Neutral continues to be the operative word on bonds. I would like to see a pullback to 4.4% to consider buying bonds. 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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