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Originally published November 22, 2004.

Okay folks, the story is the following: next week is US Thanksgiving and after that there will be 3 weeks at the most before trading shuts down for the Christmas Holidays; the majority of fixed income portfolio managers had a lousy year thus far as they were caught in a short and barbelled position during a year in which the winning theme was the 'carry-in-the-belly'. So what can we expect for the rest of the year? I would like to make the argument that the bond market should retain its positive tone for the remainder of 2004. It will be interesting to see if the Ried, Thunberg portfolio manager survey can finally break out of its 38-43 super-bearish range that it spent the better part of this year in. That should give us at least one clue if the bond market will continue to be supported by the large number of professional bears heading into 2005.

NOTEWORTHY: The economic data was mostly horrid last week. Can anybody spell stagflation? Leading Indicators declined more than expected 0.3% for the 5th month in a row, and to add insult to injury, the previous month's figure was revised down from -0.1 to -0.3%. Leaders are off 1.5% from the top and this type of decline forecasts a recession more often than not. How many economists are out there forecasting sub-3% growth for 2005?? Not many as far as I could see. At least they started revising their growth outlooks down. So heading into year-end I will look for confirmation of the slowdown forecast by the LEI data. The latest Philly Fed Survey, which declined from 28.5 to 20.7%, seems to be one data point confirming the impending slowdown forecast by the LEI. On top of this, we got some rather horrific inflation reports both at the producer and the consumer level. Never mind that most of the increases were energy related, bottom line is that living costs went up quite significantly, and consumers have no savings or wage increases to keep up. Meanwhile, indicators such as the Baltic Freight Index are signaling that we should not expect much relief on the raw materials front in the near future. While I don't think that inflation at the consumer level will increase significantly going forward, I do believe that margins will be squeezed, and profitability will be adversely affected. The Fed has hiked rates at each of its 4 meetings since the end of June and is expected to raise another 25 basis points at the last FOMC meeting of the year on December 14. I will stick with my forecast that the Fed will surprise by staying put the rest of this year and perhaps a while after that. This is subject to another 300k+ payroll print on December 3, which I do not expect to happen. I also expect the Bank of Canada to pass on raising rates at its next window on December 7.

INFLUENCES: Fixed income portfolio managers still bearish, but to a lesser degree last week (RT survey increased 2 points to 42% bullish). This metric along with the market action indicates that the year-end portfolio adjustment process has started. Specs are long +101k contracts in the 10-year Note futures, for the third week in a row. This is still bearish. However I just happened to notice, that the 'smart money' commercial crowd also happens to be long 40k contracts. In spite of more bad fundamental news, the technical picture on bonds remains constructive and last week's trading action was still bullish. As long as the bond futures contract stays above 109.50, the technical climate remains positive. Seasonals are turning positive the next week and will become stronger still heading into December.

RATES: US Long Bond futures closed at 112-23, up 11 ticks last week, while the yield on the US 10 year bond was slightly higher, up 2 basis points to 4.20%. . And even after Master Al has managed to open his big mouth again causing the long end to sell off $1 on an otherwise quiet Friday, bonds managed to eke out a small gain for the week. The front end in the US sold off on higher than expected inflation data and negative comments by Master Al, causing further curve flattening. The long end continues to have massive buyers. The Canada - US 10 year spread closed at 31, unchanged on the week. 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 97.07, up 12 cents this past week. I am planning to hold this position into the December 7 BOC announcement, unless we see a rally into the 97.30 level prior to that date. The belly of the Canadian curve under-performed the wings by 4 basis points 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 is now at a pick-up of 62 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.

CORPORATES: Corporate bond spreads were well supported last week. The buy side is way long this sector. Long TransCanada Pipeline bonds were in 1 more basis point to 117, while long Ontario bonds were .5 wider at 44.5. 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. With an ongoing slowdown ahead of us, I believe the front end is cheap in the US. The Bank of Canada will be slower to raise rates again as long as the C$ stays around 84 cents. 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.

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