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May 20, 2008

BondWorks
by Levente Mady

The Treasury market was somewhat weaker last week. In spite of mostly supportive fundamental news such as lower than expected inflation data (in the form of the CPI) and new 28 year lows on Consumer Confidence, the bond market appears to be stuck in the mud here. The US Long Bond future has traded in a narrow 3 point range for the better part of the past month and it closed the week pretty much dead smack in the middle of that range. There are a few things lining up that indicate odds are tilting more and more toward higher prices and lower yields going forward. Even if the market continues to trade sideways, it makes some sense to increase exposure to longer maturity product to earn the higher relative yields available in that sector of the bond market. When the stock market runs out of steam on this bounce, it should help bonds trade to higher levels.

NOTEWORTHY: The economic data calendar was mixed last week. Import Prices ex-oil are increasing at a 6%+ clip year over year, while overall Import Prices are rising at a 15% clip. They increased 1.1% in April alone and the trend in this data set is sharply and alarmingly positive. Retails Sales declined 0.2% in April, which matched consensus expectations. In real terms, Retail Sales have declined over 2% during the past 12 months while Consumer Credit increased close to 6% during the same time frame. That is not pretty or sustainable. The consumer has not fully hit the brick wall yet, but he/she is awful close. CPI increased a lower than expected 0.1% for the headline and 0.2% for the core component. The bond market sold off half a point on the positive news. It appears that the bond traders struggled with the credibility of the CPI news just 1 day after the 1.1% Import Price number. Weekly Jobless Claims increased 6k to 371k last week. Meanwhile for those of you that missed it, please pay attention to the news that Capacity Utilization has dipped below 80% to 79.7% and Industrial Production fell 0.7%. The experts tell us not to worry, as these numbers should be rebounding soon. I will believe that when I see it. The Philly Fed Manufacturing Index remained in negative territory at -15.6. Housing Starts rebounded sharply - up 8.2% in April. I am puzzled why builders would build more while there are record supplies of new and existing homes on the market and the downward pressure on prices is gaining momentum. I will be looking for further declines and downward revisions on this data series. The University of Michigan Consumer Sentiment Survey dropped a couple of points to 59.5. That is the lowest level for this series since 1980. Next week's headliners will include Leading Economic Indicators, PPI, and Existing Home Sales - mostly second tier data ahead of the Memorial Day long weekend.

INFLUENCES: Trader surveys have trended down for the past month and remain in neutral territory on bonds during the latest week. The Commitment of Traders reports have indicated that the commercials have a long bias in their positioning. Last week's data showed that Commercial traders were net long 242k 10 year Treasury Note futures equivalents - a decrease of 129k. The COT data is neutral with a slight positive bias. Seasonals turned positive. The 10 year yield remains below support in the 3.9 to 4% area for now. The positive factors are increasing, so I expect a bullish bias to persist here.

RATES: The US Long Bond future traded down close to a point to close at 116-14, while the yield on the US 10-year note increased 8 basis points to 3.85%. The yield curve was flatter but I am expecting that the curve will have a steepening bias. Long-short accounts can take advantage of the steepening trend by buying 2 year Treasuries against selling 10 year Treasuries on a risk weighted basis using cash or futures. This spread moved down 14 bps to 141 during the past week. It looks like the curve steepener has run into solid resistance at the 200 level. This may take months to overcome. In the mean time the range is expected to be 140 to 200.

CORPORATES: Corporate bond spreads rallied again. 10 year bank sub-debt spread moved in another 10 basis points to close the week at 185. I recommended shorting the bank sub-debt issue at Canada bonds +58 basis points a while back. A couple of weeks ago I recommended that accounts review their short exposure and fine tune it somewhat by covering half the short position. As per the comments above, I don't think we are out of the woods yet on fixed income spread product yet. We are seeing record corporate issuance across the spectrum. New product is well received and it is narrowing in. I hope this temporary recovery in credit spreads has a bit more strength, so we get a chance to reset the shorts we covered last month at better levels.

BOTTOM LINE: Bond yields moved higher across the yield curve lead by the short end. The fundamental backdrop remains bleak although the economic data was mixed last week. The fundamentals remain positive for bonds. Trader sentiment is neutral, while the COT positions and seasonal influences are supportive. My recommendation is to add to the curve steepener, continue to shun the weaker corporate credits. The market tested support again at 2.50% on 2 years and 3.90% on the 10 year note. Both these levels held the line in the sand and have the potential to head lower at this juncture. My bias remains bullish across the yield curve. Based on this view it makes sense to switch from short term (1-3 year maturities) to longer term (10 to 30 year maturities) product for 2 reasons. Number one, the longer term bonds pay higher interest rates (2.44% for a 2 year Treasury Note vs. 4.58% for a 30 year Treasury Bond) and number two, the longer term bonds have a higher price sensitivity to interest rate changes - in other words, if yields drop by equal amounts throughout the yield curve, the bonds with the longest term to maturity will have the greatest price appreciation.

Levente Mady,
Institutional Advisors

The data and comments provided above are for information purposes only and must not be construed as an indication or guarantee of any kind of what the future performance of the concerned markets will be. While the information in this publication cannot be guaranteed, it was obtained from sources believed to be reliable. Futures and Forex trading involves a substantial risk of loss and is not suitable for all investors. Please carefully consider your financial condition prior to making any investments.

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