Originally published November 15, 2004
Friday's trading in the US Treasuries illustrated very well why I am still reluctant to recommend shorting this market. Retail Sales and Michigan consumer sentiment were both stronger than expected, stocks were going parabolic, the dollar was setting new 10-year lows, so all that is bad for bonds... Or is it?? So the bond market goes up over a point in the long end, yields decline 7 basis points in 10s and longs and the curve continue to flatten. And did I mention that foreigners continue to snap up US bond supply like hotcakes and the Fed hiked rates to 2% as expected, but most markets did not even blink. Next week's main data releases will be the inflation reports (PPI and CPI), which are expected to confirm that inflation is not an issue at the core level. Leading Indicators are expected to decline for the 5th month in a row, which should be neither inflationary nor expansionary. So heading into year-end I will look for confirmation of the slowdown forecast by the LEI data.
NOTEWORTHY: The economic data was limited and mostly bond neutral last week. The consumer surveys were mixed as the Michigan Sentiment number got a post-election lift, while the other weekly surveys drifted somewhat lower, all in mildly negative territory. The Trade deficit narrowed and came in substantially below consensus, but the dollar continued to weaken in spite of the recent run of better than expected data and Fed rate hike, all of which should have helped the dollar. Well, apparently they did not, and we are back to the 2003 regime of sell the dollar and buy anything you can get your dirty paws on, be it tech stocks, large cap, OTC stocks, bonds, gold, base metals and the list goes on. The Fed has hiked rates 4 times now since the end of June. More importantly, Fed Funds doubled from 1 to 2% during this time-span. I do not expect the Fed to raise rates again in December and possibly not for a few months after. Master Al's favourite inflation measure - the Core PCE - is at 1.5%, with funds at 2%, that puts real short term rates at +.5, which is a level that I believe the Fed mopes can live with for a while.
INFLUENCES: Fixed income portfolio managers remained bearish last week (RT survey up 1 point to 40% bullish). Specs are long +101k contracts in the 10-year Note futures, same as the previous week. This is still bearish. The technical picture on bonds remains constructive and last week's trading action was definitely bullish, especially once supply was taken down. As long as the long bond futures contract stays above 109.50, the technical climate remains positive. Seasonals are becoming slightly negative for the next week or two.
RATES: US Long Bond futures closed at 112-12, up 4 ticks last week, while the yield on the US 10 year bond was unchanged at 4.18% after spending the better part of the week in the 4.20 handles. Bonds continue to have massive buyers. It appears that traders tried the short side, it did not work, so now it is time to buy it or stand aside. I don't believe we even got above the 4.30% level, so last week's recommendation to buy dips to 4.35-4.40% area just did not materialize. In case we get there, I still recommend buying some. The Canada - US 10 year spread closed at 31, in another 7 on the week. Apparently those legendary Asian clients like Canadian Provincial bonds even more than they love US Treasury bonds. Buying Canadian 10 year bonds to sell US 10 year notes and pick up 50 basis points was recommended a few weeks ago. The March05 BA futures position I bought at 97 closed at 96.95, up 9 cents this past week. The belly of the Canadian curve outperformed the wings by another basis point last week, but it is still cheap to the wings. Selling Canada 3% 12/2005 and Canada 5.75% 6/2033 to buy Canada 6% 6/2011 was a pick-up of 99 basis points half way through May. This trade is now at a pick-up of 58 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 for the Canada bond maturing in 2012 is the best risk weighted value on the curve, but the cheapness relative to the rest of the 5-10 year area has diminished.
CORPORATES: Corporate bond spreads were mixed depending on specific news last week. Bombardier credit was substantially wider on a 2 notch downgrade (20+ bps), while some other names such as TRPs and GTAAs were trading narrower. The buy side is way long this sector. Long TransCanada Pipeline bonds were in 1 more basis point to 118, while long Ontario bonds were unchanged at 44. A starter short in TRAPs was recommended at 102 back in February.
BOTTOM LINE: I like the price action on bonds even in the face of negative news and large supply pressures. An overweight position in the belly of the curve is still recommended. Short exposure for the corporate sector was advised since February. A long position was established in the March05 BAX futures under 97. Long Canada - Short US 10 year position was established at +50.
GENERAL COMMENTS: The other day I was listening to an interview with Dr. Doom-Gloom-and-Boom, a.k.a. Marc Faber. He was kind enough to point out an interesting fact that I was not aware of. The US Federal Reserve was established in 1914. During the period of the industrial revolution from 1800 to 1914, the US Dollar fluctuated up and down, but pretty much kept its value the same during the 100+ years while the US economy has gone through a phenomenal growth phase. During the 90 years since the Fed has been in existence, the Dollar managed to lose approximately 96% of its purchasing power.
