BondWorks

By: Levente Mady | Thu, Sep 8, 2005
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The 10 year US Treasury note traded below 4% last week. At the same time short term yields dropped like a stone as the interest rate markets reassessed Federal Reserve tightening expectations in the wake of the damage and destruction caused by Hurricane Katrina. The economic data released last week was collected before Katrina hit and it will take weeks if not months before the true impact of the storm will be properly understood. What we do know already is that the bill is already in excess of $100 billion. Last week Master Al, ruler of the Federal Reserve Empire, has come out and openly stated that he is targeting asset prices. Now he is caught between a rock and a hard place: does he continue to tighten and face an increased risk of recession or does he stop tightening and try to further inflate the housing bubble in order to get the economy over the risks created by the massive destruction of wealth in the aftermath of the hurricane? So far the market is telling us that the Fed will throw in the towel on tightening sooner than later. Master Al and his lieutenants have not given any indication as yet as to what course of action they plan to take next. Stay tuned for hints from Fed speakers this week. I believe the short term maturity (bonds and bills with maturity of less that 2 years) are expensive at this point.

NOTEWORTHY: The economic data was mixed at best last week. The consumer is losing confidence but continues to spend beyond its means. The Savings Rate has hit a new low of -0.6% - the lowest reading since the Great Depression. The ISM survey dropped 3 points to 53.6, also indicating that the economy is losing momentum. Non-farm Payrolls were up slightly more than the 190k expectations after the revisions were factored in. The meaningless Unemployment Rate has dropped below 5%. The upcoming week's schedule will have mostly second tier data. I am looking for the confidence surveys to continue sliding and perhaps accelerate to the downside. On Wednesday the Bank of Canada is expected to raise rates 25 basis points to 2.75% and on Friday we get the Canadian Employment Report.

INFLUENCES: The talking heads on Wall Street are still scratching their heads about declining yields; the latest Treasury market surveys are still predominantly bearish. The 'smart money' commercials are still slightly positive on the 10 year note futures, their long positions decreased from 126k to 89k this past week. This number is neutral for bonds. Seasonals are quite positive right through to the end of September. Bonds continue to trade well. 4% is resistance for 10 year notes; I expect this level to eventually give way.

RATES: US Long Bond futures closed at 117-23, up a dollar and change this past week as we switch to the December contract, while the yield on the US 10-year note decreased 16 basis points to 4.03%. The Canada - US 10 year spread was in 4 to -30 basis points. The belly of the Canadian curve underperformed the wings by 4 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 new multi-year low pick-up of 28 basis points. Assuming an unchanged curve, considering a 3-month time horizon, the total return (including roll-down) for the Canada bonds maturing in 2013 are the best value on the curve. In the long end, the Canada 8% bonds maturing on June 1, 2023 continue to be the cheapest issue on a relative basis. I have been an ongoing fan of curve flatteners as well as investing in the midterm maturity issues (a.k.a. the carry-in-the-belly) versus the long and short term maturity bonds. Both these trades have come a long way, and tend to overshoot a great deal. They have moved past their long term averages, but the trend seems to keep these dynamics in motion. While the yield curve flattening trade has been over-crowded for a while, the belly versus the wings trade is still far from popular. I am looking for these trends to stay in motion for the foreseeable future. The slight setbacks this past week have not changed my outlook on these dynamics.

CORPORATES: Canadian Corporate bond spreads were wider last week. Long TransCanada Pipeline bonds were out 4 bps to 116, while long Ontario bonds were .5 basis points wider at 46. A starter short in TRAPs was recommended at 102 in February 2004. 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. We advised to sell 10 year Canadian Bank sub-debt at a spread of 58 bps over the 10 year Canada bond a few weeks ago. This spread closed at 54 basis points on Friday - also 4 wider on the week.

BOTTOM LINE: We are sticking with our recommendation to stay long the bond market. If you were long for this move, you might consider taking some profits around 4% on the 10 year yield. We would by no means recommend short positions in the longer end (10 year + maturities) at this juncture. The sell Canada 10 year bonds to buy US 10 year notes at 46 bps or better trade is still pending, we will not chase it at this point. An overweight position in the belly of the curve is still recommended for Canadian accounts. Short exposure for the corporate sector is advised.


 

Levente Mady

Author: Levente Mady

Levente Mady,
Institutional Advisors

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