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March 02, 2005

BondWorks
by Levente Mady

I guess we had some more trash writing from the PIMCO talking heads last week. As soon as these guys quit their whining about how expensive Treasuries are and cover their shorts, I am going to establish a humongous bond-short in my personal account, but not a minute sooner. The funny thing is that both Paul McCulley last week, and now his sidekick Gross (or is it the other way around?) are coming up with all the right reasons why bond yields are so low. Then they arrive at the illogical conclusion: let's join the crowd and let's stay short. It is all about supply and demand folks. Although France has announced a new 50 year bond, the US does not seem to be ready to reopen the 30 year bond tap just as yet. Corporations are mostly flush with cash and if they need to fund, they seem to gravitate to the short end, where the cheaper money is. I did not read any headlines in the past couple of weeks about Disney or Coke or anyone else issuing 100 year bonds lately. Well, there are some long munis out there and apparently they are trading rather cheap. But the supply picture does not seem to be changing in a big hurry. And the demand side dynamics - if anything - will just be getting worse. Ask McCulley if you don't believe me. Them PIMCO guys know everything. Even if the US does not introduce legislation requiring pension funds to match Assets and Liabilities more closely, pension and insurance demand for duration will continue to increase. So when I read commentary to the effect that perhaps we could even head into stagflation and still see lower yields going forward, I say: now there is something to consider. On the other hand, when I read commentary from deflationists about the demise of bonds, I say: give your head a shake! Have y'all looked at yield curves in Australia or the UK lately: flat as a pancake to 10s and inverted beyond that. If the Fed has the guts to stay on its tightening course, that is where I expect the US yield curve to be heading.

NOTEWORTHY: It could not get much worse for bonds on the economic data front after the previous week and it didn't. CPI was a pleasant surprise by not rising in tandem with the earlier PPI report. Jobless Claims continue to show strength. The all but discarded Help Wanted Index is showing some signs of life. The job front is stronger and consequently Payroll Expectations have been ratcheted up to the 225-250k area for next Friday. Q4 GDP was revised up as expected and the Housing data continues to be strong. In addition to the all-mighty jobs report, the early part of the week will have the monthly ISM reports released. I am looking for this data series to continue to erode and provide support for bonds.

INFLUENCES: Fixed income portfolio managers still bearish. (RT survey was back down 1 point to 40% bullish. I need to see this number closer to 50% to turn negative on bonds.) Specs are now long 87k T-note contracts (versus a long position of 45k last week), which is negative. The 'smart money' commercials are still long a bullish 157k contracts (pretty much unchanged from last week's 155k). The Commitment of Traders data is overall neutral at this point. Bonds are in corrective mode, the long term trend is still positive. Market seasonals are negative going forward.

RATES: US Long Bond futures closed at 113-31, pretty much unchanged on the week, while the yield on the US 10 year bond was up 1 bp to 4.27%. My bias remains positive. The market tested and held the 4.30% resistance level in 10s so it was able to retain its positive bias. Until those levels are convincingly broken, I consider this setback as a buying opportunity in a bull market. Until positions and sentiment become less bearish, the dips will be shallow and the market will continue to power to lower yields. Month-end term extension and the early week data should provide support for the market. Increased expectations for payrolls in conjunction with portfolio positions should cushion the negative impact of a high Payroll number. The Canada - US 10 year spread was unchanged at -2 basis points. We are officially neutral on this spread at this point. Dec05 BA futures closed the week 81 basis points through Dec05 EuroDollar futures, which was out another 15 basis points from last week's close. At 62 it was an official trade recommendation to buy EDZ5 to sell BAZ5. A weakening Canadian dollar should provide support for this spread to narrow. The belly of the Canadian curve was 2 bps wider to the wings last week, but the belly is still cheap. 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 54 basis points. As the curve continues to flatten, the belly should continue to outperform. 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 look like very good value.

CORPORATES: Corporate bond spreads were stable last week. Long TransCanada Pipeline bonds were unchanged at 110, while long Ontario bonds were out 2.5 to 49.0. A starter short in TRAPs was recommended at 102 back in February 2004. Credit spreads are still excessively tight; there is loads of room to the wider side. Quality corporates should be favoured over lower rated issues.

BOTTOM LINE: I remain positive on bonds. The US front end is stuck in the mud. Liquidity is still excessive and the Fed continues to talk tough. An overweight position in the belly of the curve is still recommended for Canadian accounts. Short exposure for the corporate sector was advised since February 2004. Sell BAZ5 to buy EDZ5 at a pick-up of 62 bps or better was recommended a few weeks back.

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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