Buy Yield Curive Steeping- Buy Short-term Bonds, Sell Long-term, Bonds

By: Levente_Mady

The Treasury market was under pressure most of last week. Then on Friday, with major help from exploding energy prices, the bond market soared as yields across the yield curve dropped significantly. I suppose a pop in the Unemployment Rate from 5% to 5.5% may have helped bonds a little as well. Early in the week our tragic hero Doctor Ben of the Bernanke and Federal Reserve variety told the financial world and anyone else who wanted to listen that the Fed was most certainly done cutting rates and emphatically supports the Treasury's stronger dollar policy.

Unfortunately Gentle Ben did not even dare to dream of breaching the subject of raising rates. Frankly with unemployment skyrocketing and the real economy flailing, even the hawks on the FOMC will find it difficult to argue for higher rates. That was all fine and dandy until the European Central Bank decided to make fools out of Messrs Paulsen and Bernanke and their hollow “strong dollar” policy a couple of days later by issuing an unambiguous tightening bias and causing the US Dollar to get wasted as a result. It is refreshing to see that in some parts of the world Central Banks might actually back their inflation concerns with some action. It sure doesn't look like that is about to happen any time soon in Uncle Ben's neighbourhood. My 2 favourite trades from the past couple of letters - 1, buy bonds - sell stocks and 2, buy short term bonds - sell long term bonds, i.e. the yield curve steepening trade – worked well on Friday and I think they have further profit potential.

For all of y'all that are wondering how an inflationary energy and food complex can coexist with super low and declining bond yields, the answer is: the markets are not at all efficient; it is all about positions! And at this points the energy shorts are running for the hills and the bond shorts are not far behind them following Friday”s dismal Employment report.

NOTEWORTHY: The economic data calendar was fairly busy last week. Construction Spending declined 0.4%. The ISM Indexes are both stuck in the mud around 50 – which is neutral (i.e. zero growth) – and going nowhere fast. Auto Sales are imploding, especially on the truck/SUV front. Productivity increased at a 2.6% annual clip during the first quarter. Wee kly Jobless Claims decreased 18k to 357k last week, but Continued Benefits keep hitting new highs. The Employment report in the USA was not pretty. While the media continues to be obsessed with the fact that Non-Farm Payrolls exceeded expectations, they miss the following key points: 1, payrolls have been averaging -65k thus far in 2008; 2, 65k is not the “real” number of job losses – accounting for demographics, the adjusted number is more like -240k jobs per month; 3, the previous months' data continues to be consistently revised down; and 4, the Unemployment Rate has increased 25% thus far from the cycle lows according to the BLS statistics. Consumer Credit was up another $8.9Billion in April. It is still growing at near 6% annual clip.

My favourite website for economic data states that the financial markets pay very little attention to this report. That is unfortunate since this is the last crutch left for the consumer before he/she really falls off the spending cliff. Last week we pointed out the nasty surprise on the Canadian Q1 GDP figure. This week's ugly Canadian data was the Employment report. While on the surface a job creation of 8.4k looked ok; the problem with this number was twofold. One problem was that full time jobs actually declined a substantial 32k, while part time employment rose 41k. The other problem was that 20 to 25k jobs are the natural growth rate in Canada , and the 8k growth was well below that. It is needless to mention that the loss of momentum is both evident and troublesome. Next week's headliners will include the Trade Balance, Retail Sales, CPI and a preliminary Michigan Consumer Sentiment poll for June.

INFLUENCES: Trader surveys remain in neutral territory on bonds during the latest week. The Commitment of Traders reports showed that Commercial traders were net long 289k 10 year Treasury Note futures equivalents – a marginal increase of 9k. The COT data is neutral with a slight positive bias. Seasonals are positive. After breaking support in the 3.9 to 4% area decisively the previous week, the 10 Year Note Yield dropped back into that zone. The positive factors are still dominant, and until the 10 year yield sees some follow through 3.90%, it is going to be difficult to get excited about the technical picture.

RATES: The US Long Bond future traded up ½ a point to close at 115-03, while the yield on the US 10-year note dropped 13 basis points to 3.92%. The yield curve was steeper and I am expecting that it will retain a steepening bias. Long-short accounts can take advantage of the steepening trend by buying 2 year Treasuries against selling 10 year Treasuries on a risk weighted basis using cash or futures. This spread increased 11 basis points to 153 during the past week. It looks like the curve steepener has run into solid resistance at the 200 level. This may take months to overcome. In the mean time the range is expected to be 140 to 200.

CORPORATES: Corporate bonds remain overvalued, especially the weaker credits.

BOTTOM LINE: Bond yields declined and the yield curve was steeper last week. The fundamental backdrop remains bleak. Trader sentiment and COT positions are neutral, while seasonal influences are supportive. My recommendation is to stay with the curve steepener, and continue to shun the weaker corporate credits. 4% may be a new equilibrium on the 10 Year; and while our bond market indicators are still quite positive, it is time to keep our bullish bias in the closet a little while longer.

By Levente Mady
lmady@mfglobal.com
www.mfglobal.ca

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