By: Levente Mady | Tue, Jun 28, 2005
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Last week was anything but the expected struggle for the bond market. While the mainstream media has attributed the jitters in the stock market to $60/barrel oil, I believe that while oil is a minor contributor, it is not the main culprit of an evolving economic slowdown. The bond market has been telling the slowdown story through the flattening yield curve as well as the resilience of the long end. We also had some other indicators such as the Baltic Freight Index, the falling price of scrap steel and the struggles of the automakers signal an impending decline in the pace of economic activity. The stock market has spent the better part of 2005 in negative territory; however it established a minor uptrend since the middle of April. Thursday and Friday last week stocks sold off hard while bonds traded up. It was the first time in a while that both markets seemed to be trading on economic concerns. It will be interesting to see if this trend can gain some momentum on both fronts. With the exception of the few days around month/quarter-end, the seasonal tendencies are negative for stocks and positive for bonds. Unfortunately the consumer does not have much in the way of savings to help cushion the negative climate that lies ahead.

NOTEWORTHY: The economic release calendar was light last week. The theme continues to be one of weakness and fading momentum. Leading Economic Indicators declined again as expected and they are declining at 1.9% year-over-year rate at last count. While the mainstream economist community continues to trash and/or ignore this metric, we do believe that it is giving us worthwhile information about what lies ahead. And the information we are getting is quite negative. Durable Goods Orders looked good at first blush but the Ex-Transport Core component (which strips out volatile airplane orders that are not expected to be filled for up to 10 years) was not only negative for the second month in a row, but also lower than expectations and the previous month's figure was revised down. Housing continues to be very strong, but New Home Sales also failed to top - very high - expectations and also had the previous month's figure revised down. Weekly Jobless Claims were a bright spot, indicating that the job market is in ok shape for now. Next week's highlight will be the contents of the statement released after the FOMC Meeting wraps up on Thursday afternoon. Another 25 basis point rate hike is universally expected, most Fed officials have indicated that the Fed still plans to continue its measured rate hikes, but the market will be watching for any clues if their resolve has weakened in light of slower than expected economic data. In addition we will get another smorgasbord of economic surveys that are supposed to aid in our crystal gazing with regard to the economy's future.

INFLUENCES: Fixed income portfolio managers are becoming less bearish, in step with the sell side strategist crowd. (RT survey held at a multi-month high reading of 45% bulls over the latest week. This metric is now into neutral territory from a contrarian perspective.) The 'smart money' commercials are long 216k contracts (a fourth consecutive increase from last week's 194k). This number is becoming positive again 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 neutral heading into the latter part of the month. After struggling for a week and a half, the bond market put in a solid performance last week. On the technical front, bonds are closing in on the highs again. The technical landscape is positive; the bears are losing the battle.

RATES: US Long Bond futures closed at 118-30, up over $2 this week, while the yield on the US 10-year note fell 15 basis points to 3.92%. The lack of follow through to higher yields and the ease with which the 10 year note sliced through the 4% level again send me scrambling to cover my earlier trading short recommendation. The Canada - US 10 year spread was narrower by 1 to -17 basis points. We are officially neutral on this spread at this point. The belly of the Canadian curve outperformed the wings by 4 basis points last week and broke through the 40 bps level for the first time in years. 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 39 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 be cheap on a relative basis.

CORPORATES: Corporate bond spreads continue to grind in for most sectors, except autos. The new issue tap is wide open. Long TransCanada Pipeline bonds were in another 2 to 123, while long Ontario bonds were in .5 to 47. 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 was covered for short term oriented accounts 2 weeks ago. 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.


Levente Mady

Author: Levente Mady

Levente Mady,
Institutional Advisors

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