Below is a commentary published at Institutional Advisors on 21 February 2005.

Well, pretty much everything that could go wrong went wrong for bonds last week. First we had illustrious individuals like Master Al, Chairman of the Fed and Paul McCulley, spokesperson for the world's largest, most successful bond fund (how do these guys do it anyway, having been beared up on bonds for the better part of the past year and a half???) telling us what a conundrum it is to have bond yields at such outlandishly low levels. Then we had mostly bond negative economic news on the growth front and especially on the inflation front. And then, as if all that was not enough, the French announced that they planned to introduce a new 50 year government issue. This got the rumour mill going about potential reopening of the 30 year supply tap in US Treasuries as well. As a result we are back to where we started the year on 10 year Treasury Notes at 4.25%.

NOTEWORTHY: It was mostly ugly news for bonds on the economic data front last week. Jobless Claims continue to show strength. Building Permits are at all-time highs, the Philly Fed Survey bounced back 10 points (from 13 to 23) and - the real bond killer - core-PPI was up 0.8% in January. Not many seemed to pay attention to consumer sentiment deteriorating or Leading Indicators clocking a negative reading for the 6th time in the past 8 months. As far as Master Al's testimony was concerned, politicians were largely unconcerned with rising rates, all they wanted to drill him about was Bush's Social Security Plans. It was rather amusing to read the left wing commentary (Krugman in the NYT) branding Mr. G. as another partisan hack for his perceived support of Social Security privatization, while the right wing press (Bloomberg columnist John Berry) was kind enough to describe how that same Mr. G. undermined the administration's plans on the same issue. The guy gets no respect, but on the other hand he did manage to talk the bond market down for a couple of days anyway. Next week shapes up to be sedate relative to last. Bond market participants will pay extra attention to the CPI data to be released in Wednesday to see if it confirms the rise observed on the PPI front last week.

INFLUENCES: Fixed income portfolio managers still bearish. (RT survey was up 1 point to 41% bullish. I need to see this number closer to 50% to turn negative on bonds.) The latest JPM portfolio manager survey finally achieved perfection at 0% (yes folks, that is 0 as in ZERO, NADA, ZILCH) bulls. It don't get much better than this. Specs are now long 45k T-note contracts (versus a short position of 6k last week), which is neutral sentiment. The ‘smart money' commercials are still long a bullish 155k contracts (an decrease of 65k from last week's 220k). Bonds are in corrective mode. Market seasonals are negative going forward.

RATES: US Long Bond futures closed at 113-30, down close to $2 on the week, while the yield on the US 10 year bond was up 18 bps to 4.26%. My bias remains positive. The market needs to stay below 4.30% in 10s and 4.75% in the long end to retain its positive bias. Until those levels are convincingly broken, I consider this setback as a buying opportunity in a bull market. Until positions and sentiment become less bearish, the dips will be shallow and the market will continue to power to lower yields. The Canada - US 10 year spread moved in 10 to -2 basis points. We are officially neutral on this spread at this point. Dec05 BA futures closed the week 66 basis points through Dec05 EuroDollar futures, which was out 5 basis points from last week's close. At 62 it was an official trade recommendation to buy EDZ5 to sell BAZ5. A weakening Canadian dollar should provide support for this spread to narrow. The belly of the Canadian curve was a snick wider to the wings last week, but the belly is still cheap. 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 52 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 (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 stable last week. Long TransCanada Pipeline bonds were unchanged at 110, while long Ontario bonds were in .5 to 46.5. A starter short in TRAPs was recommended at 102 back in February 2004. Credit spreads are still excessively tight; there is loads of room to the wider side. Quality corporates should be favoured over lower rated issues. As my colleague Bob Hoye mentioned in his Pivotal Events last week, one way to look to position a trade to take advantage of widening high yield spreads is through shorting MSD. MSD is the Morgan Stanley Emerging Markets Debt Fund listed on the NYSE. This is a good instrument for retail investors to consider trading in as a proxy for high yield bonds. It offers some diversification within the emerging debt market, it is Exchange traded, so it can be bought or sold (shorted) just like a stock. The chart on MSD looks like it is topping after a solid run. Investors looking for exposure in the high yield space should consider shorting this instrument.

BOTTOM LINE: I remain positive on bonds. The US front end is stuck in the mud, but it is still cheap and seems to get cheaper. An overweight position in the belly of the curve is still recommended for Canadian accounts. Short exposure for the corporate sector was advised since February 2004. Sell BAZ5 to buy EDZ5 at a pick-up of 62 bps or better was recommended a few weeks back.