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August 26, 2005

BondWorks
by Levente Mady

Well folks, we are into the second last week in August. The financial markets seem to have a slow, tired attitude reflecting the fact that a significant number of market players are away on their summer holidays before the gong sounds right around Labour Day. Bonds did manage to turn in another positive week in spite of less than stellar inflation data this past Wednesday. On the surface the all-mighty consumer is still doing fine. The consumer is over 70% of the US economy so more than ever the consumer is key. The latest housing numbers were strong but evidence is increasing that the sector is running on fumes now. While we read gloom and doomers such as Yale professor/economist Robert J. Shiller and a few others warn of a real estate bubble that is ready to burst, the mainstream view is still one filled with warm and fuzzy feelings towards this asset class. The publicly traded equities of the homebuilders have had a spectacular run over the past couple of years. These stocks are leading indicators of the health of the housing sector. Homebuilders had another quarter of stellar earnings reports as well as record amounts of insider share sales. In spite of the strong earnings, the stocks have turned lower since the beginning of August. These stocks, along with sub-prime lenders, are worth keeping an eye on in order to gauge not only the shape the housing sector is in but also for the bigger picture on the consumer. Wage growth is not even keeping up with inflation, so if house prices stop skyrocketing, the consumer will have a tough time finding new money to continue spending like there is no tomorrow.

NOTEWORTHY: The economic data was mixed last week. While core CPI had a tame reading for the fourth month in a row, PPI provided a huge upside surprise both on the core and the headline number. The most recent slew of inflation numbers does not change my opinion one bit that deflation will be more of an issue than inflation going forward. Last month it was reported that Capacity Utilization finally hit 80% in June, over 3 years into the recovery. Well, apparently that was a false start. June's number was revised down to 79.8% and July's figure was reported at 79.7%. It doesn't look like there is much inflation pressure coming from this front. The latest housing sector data shows continued strength in the sector. The upcoming week's schedule includes more housing related reports as well as the Durable Goods Order data for July. These reports - along with the usual weekly surveys - constitute secondary data that rarely influences the market a great deal. The Canadian economic calendar on the other hand has Retail Sales and CPI scheduled to be released next week.

INFLUENCES: The latest Treasury market surveys are still predominantly bearish. The Reid Thunberg fixed income survey has been ticking up. The 'smart money' commercials are still positive on the 10 year note futures, their long positions are slightly less than last week, at 90k, down from 122k the prior week. This number is slightly positive for bonds. Seasonals are becoming quite positive right through to the end of September starting this week. Bonds had a decent tone last week, they were able to hold and add to last week's gains.

RATES: US Long Bond futures closed at 116-08, up a quarter this past week, while the yield on the US 10-year note decreased 3 basis points to 4.21%. The Canada - US 10 year spread was out 3 to -30 basis points. The belly of the Canadian curve outperformed the wings by another 5 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 2012 and 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.

CORPORATES: Canadian Corporate bond spreads narrowed last week in spite of increasing equity volatility. Normally equity volatility and corporate spreads move together. I believe the divergence is temporary and will resolve itself to the upside. Long TransCanada Pipeline bonds were 2 tighter at 114, while long Ontario bonds were also stable at 44.5. 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 52 basis points on Friday - also 2 tighter on the week.

BOTTOM LINE: We recommended buying bonds on dips to the 114 level on the Long Bond future. We are officially long the market at this point. 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. We recommended an increase in short corporate exposure recently.

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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