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November 03, 2005

BondWorks
by Levente Mady

So Ben Bernanke was nominated to succeed Alan Greenspan as the next Chairman of the US Federal Reserve and the knee-jerk reaction of the bond market was negative. The 10 year bond yield increased 20 basis points on the week, but it could have been worse if it wasn't for bond friendly data and the fact that our man Ben was the odds-on favourite for the job. We have all seen and heard an endless stream of comments about the heir apparent, so I find it futile to re-hash the man's credentials, work, inclinations, favourite colour, etc. A couple of issues are quite obvious however. First, the initial market reaction - bonds down and stocks up - implies that he is perceived as a person with dovish inclinations. Second, the storm clouds are gathering above the economy and it is a virtual certainty that he will be tested early in his reign at the Fed. The mainstream commentary tells us that Double B has all the credentials and will have all the answers to ensure a speedy approval through the nomination process. However, we will have to wait until next year to find out whether he has what it takes to steer the Fed through thick and thin in smooth fashion.

NOTEWORTHY: The economic data was disappointing last week. Although the market cheered the release of the stronger than expected preliminary Q3 GDP report, that number is old news, it is incomplete and it is a lagging indicator. The housing data, while still strong, is starting to disappoint. In addition to a worrisome increase in inventory levels, the latest set of reports on this front had data reported for previous months revised down. The Philadelphia Housing Sector Index has declined close to 20% from its all-time high at the end of July, forewarning that all is not peachy on the home front. All three Consumer Confidence surveys were disastrous this past week. The Conference Board survey was expected to bounce in October, but instead plunged to new lows. The weekly ABC poll declined 2 points to -19. The University of Michigan Confidence survey meanwhile hit a fresh 14 year low at 74.2. Durable Goods Orders were also reported weaker than expectations for the month of September. As mentioned in this column before, Consumer Confidence plumbing new depths is particularly worrisome and unless it starts to rebound in an emphatic fashion, it does not bode well for the upcoming Christmas shopping season. I do not expect it to recover any time soon. Next week's economic calendar gets us into November. The Month will start off with the usual ISM surveys as well as with another 25 basis point Fed rate hike to 4% on Tuesday, November 1. The excitement on Tuesday will be followed by the monthly labour data scheduled to be released Friday morning.

INFLUENCES: The latest Treasury market surveys are still predominantly bearish. The 'smart money' commercials have increased their long positions in the 10 year note futures from 128k to 239k this past week. This number is supportive for bonds at this point. Seasonals are now positive for the bond market. On the technical front, the 10 year Treasury note has broken through the 4.5% level and stayed above that yield.

RATES: US Long Bond futures closed at 116-26, down close to $2 this past week, while the yield on the US 10-year note increased almost 20 basis points to 4.57%. The Canada - US 10 year spread moved out 6 bps to -41 basis points. This spread has room to narrow, so traders are advised to remain short Canadian 10 year bonds against a long position in US 10 year bonds. This trade was initiated at pick-up 50 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 pick-up of 20 basis points, giving back the 4 basis point gain from the previous week. The recommendation regarding the overweight position in the intermediate maturities of the yield curve is to take a few chips off the table, but not to completely exit the trade as yet. Assuming an unchanged curve, considering a 3-month time horizon, the total return (including roll-down) for the Canada bond maturing in 2014 is the best value on the curve. In the long end, the Canada 8% bonds maturing on June 1, 2023 are no longer a good value on a relative basis.

CORPORATES: Canadian Corporate bond spreads were wider last week. Long TransCanada Pipeline bonds were 1 wider at 116, while long Ontario bonds were .5 wider at 48.5. 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 59 basis points on Friday - out 2 basis points on the week. Canadian credit spreads are not only expensive relative to historical averages, but also relative to international spreads.

BOTTOM LINE: The bond market did not react well to Ben Bernanke's nomination to succeed Alan Greenspan at the helm of the Federal Reserve. The bond market is not trading well, the outlook is neutral at best. The yield curve is expected to retain its flattening bias. A trading position was initiated to sell 10 year Canada Bonds to buy 10 year US Treasury Notes. An overweight position in the belly of the curve is still recommended for Canadian accounts, but to a less extent than over the past 2 years. Ongoing underweight exposure for the corporate sector is strongly advised.

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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