Only one word is needed to characterize Friday's action in the long end of the Treasury market: UGLY - as in capital U, capital G, capital L and capital Y, U-G-L-Y. Bond friendly payroll data far below any "official" predictions got the bond rally going, but before long bonds turned around and ended plunging, closing on the lows of the day, forming a technical pattern known as a key-reversal day. In the short term the market has been severely wounded. I believe that a follow through to a 10 year yield past 4% will open the door to a minimum 4.25%. So all you little fundamental traders out there, don't fret about the soft-patch becoming a "rough-patch", just consider more important events such as another chief bond bear (Stephen Roach of Morgan Stanley fame) actually joining the bullish crowd of such notables as Bill - the Bond King - Gross and David - there is no inflation my Darlings - Rosenberg. While supply is not an issue in a bull market, after seeing such adverse reaction to solidly bullish numbers on Friday, the next test of the short-term health of the bond market will most likely be the 5 and 10 year Treasury note auctions on Wednesday and Thursday. That said, this weekend we have goldbugs, taxi drivers, real estate agents, more Wall Street strategists - the cream of the contrarian indicator crop - all advising us to sell bonds. In the short term I can't help but nervously agree with them. Longer term I am just not prepared to declare the bond bull quite dead yet.

NOTEWORTHY: Last week just confirmed what we have been harping on for weeks: this economy ain't going nowhere but down. Sure you could argue that Consumer Confidence is bouncing back, but that is a bull trap that mirrors the stock market action. On the other hand we have ISM Manufacturing continuing to plunge - and now within spitting distance of the magic 50 level, Weekly Claims are now up to 350k - a healthy 25k bounce from the previous week, and the payroll data was an unmitigated disaster that has been widely advertised. One detail that I have not noticed in the media coverage is that without the business birth/death plug factor the Non-Farm Payrolls would have read -129k... let's just call it an unmitigated disaster and be done with it. The week ahead will be fairly quiet on the economic calendar. The Trade data released next Friday will be of some interest and Master Greenspan's comments in front of the Congress are expected to potentially have some market moving effects on Thursday.

INFLUENCES: Fixed income portfolio managers have been steady bearish. (RT survey was down 1 point over the latest week. This metric is somewhat bullish from a contrarian perspective.) The 'smart money' commercials are long 116k contracts (a slight increase from last week's 105k). This number is definitively neutral for bonds. Seasonals are strongly positive in June. On the technical front, we traded to 3.8% on the US 10 year notes on Friday morning, but closed the day 17 basis points higher at 3.97%. The market has breached the 4% level substantially, but it remains to be seen if it can stay under on a lasting basis without some compelling fundamental evidence.

RATES: US Long Bond futures closed at 117-27, up close to $1.5 on the week, while the yield on the US 10-year note was 10 basis points lower at 3.97%. My bias is negative in the very short term - for the next week or two. The Canada - US 10 year spread was wider by 2 to -11 basis points. We are officially neutral on this spread at this point, but leaning towards selling Canada to buy US bonds. Dec05 BA futures closed the week 98 basis points through Dec05 EuroDollar futures, which was out 2 basis points from last week's close. At 62 it was an official trade recommendation to buy EDZ5 to sell BAZ5. This trade is a waste of time, we will be looking to exit gracefully. The belly of the Canadian curve underperformed the wings by 3 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 pick-up of 47 basis points. 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 are cheap.

CORPORATES: Corporate bond spreads were tighter last week. Long TransCanada Pipeline bonds were unchanged at 127, while long Ontario bonds were in 1.5 to 48.5. A starter short in TRAPs was recommended at 102 back in February 2004. Corporates have been narrowing for the past few weeks, but I believe they are close to ending this trend. 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.

BOTTOM LINE: Neutral continues to be the operative word on bonds. A trading short is recommended for aggressive short term oriented accounts again this week. If the US 10 year note does not trade above 4% by Thursday at the latest, cover your short positions. Clients who are long the bond market (still few and very far between), should consider selling to get closer to a neutral position, shorts are advised to cover on dips to 4.25%. An overweight position in the belly of the curve is still recommended for Canadian accounts. Short exposure for the corporate sector is advised. After a brief pause, this sector is expected to move substantially wider going forward. Sell BAZ5 to buy EDZ5 at a pick-up of 62 bps was recommended a few weeks back.