By: Levente Mady | Thu, Jun 16, 2005
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The bond market traded in a remarkably resilient fashion last week, until Friday again. The economic calendar was light and of no consequence, the Treasury auctions were met with better than average demand and Master Al's hawkish tone implying that on-going measured rate hikes are to be expected was pretty much ignored on Thursday. Then, for the second Friday in a row, in spite of market friendly data, the trade was consistently one way: towards higher yields as 10 year Treasury notes broke through the 4% barrier in convincing fashion. On the supply front, I believe that as the yield curve flattens and the economy slows, the market will be faced with a new headwind of increased long term supply. On the Treasury supply front, the best days of shrinking budget deficits are behind us; we can start looking for upside surprises on the US Budget deficit front. On the corporate bond front, last year with an ultra-steep yield curve it made a ton of sense to raise short term debt or to swap long term debt into floating rate debentures based on 1% Fed Funds. Fed Funds are now at 3% and still rising and for the extra 1-2% (vs. 5-6% last year) most corporate Treasurers are now looking to lock in longer rates.

NOTEWORTHY: Last week's economic data was sparse and mostly bond friendly. Consumer Confidence continues to bounce back in step with the stock market action. The US Trade deficit was slightly lower than expected, while Import Prices declined significantly. The Budget Deficit has also shrunk beyond consensus expectations. The week ahead will be quite busy on the economic front. In addition to a long list of Fed-head types scheduled to comment on a variety of topics, there will be inflation data - PPI, CPI -, consumer data - Retail Sales, Housing Starts, more confidence surveys -, industrial data - Industrial Production, Capacity Utilization and more surveys and reports on this front also. This long list of items is expected to provide further evidence that the economy is slowing. Meanwhile the Canadian economic data reported last week was deceptively strong. Both the Trade Surplus and the Employment Data was better than expectations.

INFLUENCES: Fixed income portfolio managers are becoming less bearish, in step with the sell side strategist crowd. (RT survey was up 2 points to a multi-month high reading of 43% bulls over the latest week. This metric is somewhat bullish but heading into neutral territory from a contrarian perspective.) The 'smart money' commercials are long 148k contracts (a small increase from last week's 116k). This number is definitively neutral for bonds, however the change in trend and the fact that commercial accounts have started to increase their long positions can be interpreted as somewhat bearish. Seasonals are positive in June, but become more neutral heading into the latter part of the month. On the technical front, we traded to 3.8% on the US 10 year notes a week ago, but closed last week through 4%. The market has traded substantially below 4%, but it struggled to hold under that level, settling at 4.05%. The technical landscape is negative short term.

RATES: US Long Bond futures closed at 117-09, down just over half a buck, while the yield on the US 10-year note was 8 basis points higher at 4.05%. My bias is negative in the very short term - for the next week or two. The Canada - US 10 year spread was wider again by 6 to -17 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 103 basis points through Dec05 EuroDollar futures, which was out 2 basis points from last week's close. At 62 it was an official trade recommendation to buy EDZ5 to sell BAZ5. With Master Al indicating last week that the Fed will continue to ease, we have no choice but to exit this trade with a substantial loss. The belly of the Canadian curve outperformed the wings by 7 basis points 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 40 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 be cheap on a relative basis.

CORPORATES: Corporate bond spreads were slightly tighter again last week. The new issue tap is wide open. Long TransCanada Pipeline bonds were unchanged at 127, while long Ontario bonds were in .5 to 48.0. A starter short in TRAPs was recommended at 102 back in February 2004. Corporates have been narrowing for the past few weeks, but I believe they are close to ending this trend. 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. A trading short is recommended for aggressive short term oriented accounts last week. Although the US 10 year note did not trade above 4% until Friday, my negative short term bias is retained. Clients who are long the bond market (still few and very far between), are strongly urged to get closer to a neutral position, shorts are advised to be patient and cover on dips to 4.25%. 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 while back. This trade did not work out; it is recommended to exit at a loss of approximately 41 bps.


Levente Mady

Author: Levente Mady

Levente Mady,
Institutional Advisors

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