BondWorks

By: Levente Mady | Thu, Jul 28, 2005
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Bonds had another less than stellar week. The major event in the financial market was not the Master Al show as advertised, but the revaluation of the Chinese Yuan by the People's Bank of China. Although the revaluation was insignificant, it has caused a sharp sell-off in the bond market. The bottom line is that the PBOC is still setting the Yuan rate at its discretion and it remains to be seen if and when further adjustments will be made. As far as the impact on the bond market is concerned, other than some short term volatility, I expect the long term effect to be minimal. While the mainstream media seems to be taking the slew of recent major layoff announcements in stride, I believe that this trend is another significant headwind that consumer faces in its struggle to continue the power spending that has fuelled this recovery thus far. Master Al in the meantime did not have any surprises for the market during his testimony. As expected, he repeated the mantra of continued measured rate hikes. His remarks were not supportive for the bond market.

NOTEWORTHY: The economic calendar was light and mostly positive again last week. Housing data is still strong, consumer and manufacturing surveys continue to bounce back, Weekly Jobless Claims were lower than expected. While on the surface economic indicators look encouraging, I am not sold on the idea that the economy can grow at a 3-4% clip indefinitely. The imbalances that have existed are not getting eliminated and the headwinds from the ongoing Fed rate hikes and the stronger dollar are just increasing. On the Canadian front, the latest CPI release has confirmed that inflation is not an issue in Canada either. At 1.5% and falling, core CPI is closing in on the lower end of the Bank of Canada's target band of 1-3%. My bet is that we will see 1% before we see 2% on this metric. The Bank of Canada is on a witch-hunt, and they will likely raise rates heading into the fall as they desperately search for signs of impending inflation that will just not be forthcoming. The upcoming week's schedule includes some minor economic data on the housing front, the durable goods report, more surveys and a smattering of the usual weekly reports. On the equity side, reporting season will continue in full force. News and stock market reaction on this front will have an impact on rates.

INFLUENCES: The recent slide in the Treasury market had the bond bears increase the volume of their negative chatter. Hedge-funds were selling the Yuan news in droves last week, but the market - while bending somewhat - did not feel like it was ready to break. The 'smart money' commercials have increased their positions slightly to 163k contracts (from last week's 154k). This number is becoming slightly positive again for bonds. Seasonals are neutral and choppy in July. Bonds continue to give up ground and broke through some key levels last week. The Long Bond Futures broke down through the 116 level, so the technical scene looks neutral at best. On the other hand, considering the bad news that bonds had to weather, the longer maturities have traded quite resiliently and I believe they have limited downside potential going forward. The next support on the Futures is at 114. I am looking for this level to provide solid support, if we manage to trade down there.

RATES: US Long Bond futures closed at 115-27, down another half a dollar last week, while the yield on the US 10-year note increased 5 basis points to 4.22%. 10 year notes broke second support at 4.20% and traded as high as 4.28% before rebounding somewhat. The Canada - US 10 year spread was 10 wider to -35 basis points in spite of continued tough talk from the Bank of Canada talking heads last week. We are getting close to levels where we will look to sell Canadian bonds to buy Treasuries. The belly of the Canadian curve slightly underperformed the wings 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 37 basis points, 2 basis points higher than the prior week. Assuming an unchanged curve, considering a 3-month time horizon, the total return (including roll-down) for the Canada bond maturing in 2013 is the best value on the curve. Bond market participants not only in the Canadian government bond market, but also in provincial and corporate issues are advised to shift the focus of their investments to this part of the maturity spectrum. 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 wider last week. Long TransCanada Pipeline bonds were unchanged at 116, while long Ontario bonds were out .5 to 45.5. A starter short in TRAPs was recommended at 102 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. As a new recommendation we advised to sell 10 year Canadian Bank sub-debt at a spread of 58 bps over the 10 year Canada bond. This spread closed at 53 basis points last week - 1 bp wider than the previous level.

BOTTOM LINE: Neutral continues to be the operative word on bonds. An overweight position in the belly of the curve is still recommended for Canadian accounts. The inflection point on the Canadian yield curve is shifting from the 2011-2012 bonds to the 2013 maturity area. Short exposure for the corporate sector is advised. We recommended an increase in short corporate exposure recently.


 

Levente Mady

Author: Levente Mady

Levente Mady,
Institutional Advisors

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