Trading was subdued in the bond market this past week ahead of the long weekend in the US. That however did not stop Treasury bonds from grinding higher. We had a 'liquidity' week in the financial markets, as stocks, bonds, and commodities (especially energy) all improved through the week. By the latter part of the week even the out-of-favour gold stocks decided to show some signs of life. While Europe is heading into turmoil with the projected "NO" on the upcoming French vote on the European constitution, that does not seem to matter much as far as disturbing the positive trajectory that most markets have embarked on.
NOTEWORTHY: Last week was busy with minor data on the economic release front. Most of the data was very close to expectations, so we had no large surprises to catalyze trading. The Housing sector continues to power ahead with record (or close to record) numbers. Durable goods were strong on the headline figure but disappointing when the volatile transportation component was stripped out. Consumer sentiment improved somewhat with the bounce in stocks, but remains at low absolute levels. The consensus picture for the economy remains for solid and steady growth as per the confirmation provided from the upward revision of the Q1 GDP data to 3.5%. Last week we also had our first major Wall Street strategist join the dark (bond bull) side, looking for 3 handles on the 10 year note going forward into next year. With the Bond King turning positive last week and one out of 70 odd Major Strategists on board now, the bullish bond bandwagon is starting to feel uncomfortably crowded. Next week will be more lively on the data front as we get fresh May data first on the ISM front and then the famous Employment data on Friday. While consensus might be a tad optimistic looking for 183k, I do not believe the Payroll number will be a huge surprise this week.
INFLUENCES: Fixed income portfolio managers have been steady bearish. (RT survey was not available for the latest week, so we assume little change to last week's 42% bullish figure. This metric is somewhat bullish from a contrarian perspective.) The 'smart money' commercials are now only long 105k contracts (a substantial drop from last week's 302k). This number is definitively neutral for bonds. Seasonals are strongly positive heading into June. On the technical front, we traded to 4% on the US 10 year notes on Wednesday, but the rally stalled at that key level for the time being. This level has proved to be the bottom of the recent trading range in 10 years. I believe it will be difficult to breach the 4% level on a lasting basis without some compelling fundamental evidence.
RATES: US Long Bond futures closed at 116-14, up a half on the week, while the yield on the US 10-year note was 5 basis points lower at 4.07% after trading as low as 4.0% during the week. My bias is neutral, and I can't believe I even considered shorting this conundrum. The Canada - US 10 year spread were wider by 6 to -9 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 96 basis points through Dec05 EuroDollar futures, which was out 14 basis points from last week's close. At 62 it was an official trade recommendation to buy EDZ5 to sell BAZ5. This trade is a waste of time, we will be looking to exit gracefully. The belly of the Canadian curve outperformed the wings by another basis point last week as the belly continues to outperform the wings on the rally. 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 44 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 are dirt cheap.
CORPORATES: Corporate bond spreads were tighter last week. Long TransCanada Pipeline bonds were in 1 basis point to 127, while long Ontario bonds were also in 1.0 to 50. A starter short in TRAPs was recommended at 102 back in February 2004. Corporates are settling down somewhat, as expected before the next shoe drops. 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 during the next 4-6 weeks. Look to sell the bounce.
BOTTOM LINE: Neutral continues to be the operative word on bonds. A trading short was recommended for aggressive short term oriented accounts 2 weeks ago, but that was a mistake. The US 10 year note has hit 4% - a major resistance level. Clients that are long the bond market (still few and very far between), should consider selling to get closer to a neutral position, shorts are advised to cover on dips to 4.25% or if the 4% level is broken. An overweight position in the belly of the curve is still recommended for Canadian accounts. Short exposure for the corporate sector is advised. After a brief pause, this sector is expected to move substantially wider going forward. Sell BAZ5 to buy EDZ5 at a pick-up of 62 bps was recommended a few weeks back.
GENERAL COMMENTS: While all might appear to be fine and dandy with tech stocks leading the rally, the Baltic Dry Freight Index just keeps ticking down. After breaking major support at 4000 at the beginning of May, the latest print was 3279 and falling and closing in on the 2004 low of 2633. Caution is advised.