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May 12, 2005

BondWorks
by Levente Mady

We had quite a week in bond land: a truckload of fresh economic data, the Fed raising rates as expected, but messing up and re-releasing its statement (not quite as expected), the Treasury announcing plans for re-introducing 30 year auctions, fireworks on the auto front, rumours of imminent loosening of the China peg and the list goes on... I will deal with the economic landscape in the next paragraph. The renewal of the 30 year auction was a gift from the Treasury to those parties who were looking to get involved with the ongoing flattener, but have not done so yet. My bet is that they missed the boat again. 2s-30s got as low as 84 basis points prior to the announcement, promptly blew out to 105, but low and behold, by week's end, that spread was back down to 90 basis points. The curve will continue to flatten folks and the day is not far when 2 year Treasuries will be yielding more than 30 year Treasuries will. A $20-30 billion annual supply of 30 year bonds will make approximately 0.001 iota of difference in the grand scheme of the bond market universe. Please refer to yield curve changes in France, Holland, Spain and the UK for a starting point. Those are countries that recently introduced or announced long government bond auctions of maturities varying between 30 and 50 years.

I am not going to detail the Kerkorian bid and the S&P downgrade of GM and Ford credits to junk or the market reaction to these events. What I would like to note is that while auto paper got severely hurt again this week, most other credit was unchanged if not slightly better. I guess Mr. Market is telling us that the suffering in the auto sector is isolated and will not have any impact anywhere else. Let's take the beautiful Province of Ontario, Canada as an example. Ontario spreads were better by 1.5 basis points last week. 1 in 6 jobs in Ontario have some sort of connection to the auto industry (second in concentration only to the great state of Michigan in North America). What Mr. Bond Market is telling us is that the pain in the auto sector will have no effect on jobs, consumption, housing, tax revenue or anything else in Ontario. Time will tell.

NOTEWORTHY: We had a very busy week on the data release front. The ISM Manufacturing survey hit a fresh 21 month low. ABC Consumer Confidence hit a fresh 11 month low. Auto sales were higher than expected on heavy discounting. Weekly Claims crept a little higher again to 333k. Payrolls were reported at a measly +25k, which was transformed into an impressive 274k with the help of the "Birth-Death rate adjustment" in the US. The Canadian employment data was reported at a solid +29k, unfortunately private sector only contributed -9k (as in a loss of 9k jobs), while manufacturing jobs were down 29k (US equivalent would be near -300k). The soft patch is officially over, what is next? Could the opposite of a "soft patch" be a "rough patch"?

INFLUENCES: Fixed income portfolio managers have been steady bearish. (RT survey for the latest week was stuck at 41% bullish. This metric is somewhat bullish from a contrarian perspective.) The 'smart money' commercials are still long 262k contracts (off from last week's 320k). This is the 7th straight weekly decline, and it is moving to neutral territory. Seasonals are negative into the second week in May. On the technical front, the tone remains positive as long as 4.42% holds on the US 10 year notes.

RATES: US Long Bond futures closed at 114-00, giving back the previous week's one point gain, while the yield on the US 10-year note was up 6 basis points to 4.26%. My bias is neutral, but I believe there is a trading opportunity to sell bonds for the next few weeks. The Canada - US 10 year spread has narrowed 3 to -3 basis points. We are officially neutral on this spread at this point, but leaning towards selling Canada to buy US bonds. Dec05 BA futures closed the week 81 basis points through Dec05 EuroDollar futures, which was 2 basis points narrower from last week's close. At 62 it was an official trade recommendation to buy EDZ5 to sell BAZ5. The belly of the Canadian curve underperformed the wings by 1 bp 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 49 basis points. 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 mixed last week. Long TransCanada Pipeline bonds were unchanged at 129 (out almost 20 basis points in the past month or so), while long Ontario bonds were in another 1.5 to 51. A starter short in TRAPs was recommended at 102 back in February 2004. Auto-paper land was wider again on the news of GM and Ford bond downgrades to junk status by S&P. 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. Corporate spreads have widened considerably, so a pause and perhaps a bounce is due during the next 4-6 weeks. Look to sell the bounce.

BOTTOM LINE: Neutral continues to be the operative word on bonds. A trading short is recommended for aggressive short term oriented accounts 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. After a brief pause, this sector is expected to move substantially wider going forward. 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.

Copyright © 2004-2008 Institutional Advisors

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