Bonds Crash as Stock Markets Bounce

By: Levente_Mady

The bond market traded sharply lower again last week as tiny glimmers of hope appeared on the horizon indicating that the worst of the financial upheaval for this month might be behind us. After a record breaking crash in equities during the first third of October, stocks actually managed to show some gains last week as some metrics of financial distress such as elevated LIBOR levels, 0% Treasury Bill yields and record premiums for Credit Default Swaps managed to subside a tad. We are far from normal on most fronts but at least for the moment it appears that the sky has stopped falling!

Central Banks have been slashing rates world wide but it did not seem to help much. The Bank of Canada will likely cut its lending rate from 2.5% again at its policy meeting on Tuesday. Central Banks will continue to be in easing mode for the foreseeable future.

Canadians went to the polls last week and re-elected a minority Conservative government. Frankly, at this point it did not seem to matter much who won the election, as neither stocks nor the bond and currency markets bothered even with a collective yawn to acknowledge the results. While I hear ongoing commentary about how solid the banking sector is in Canada and that we don't have to deal with the same excesses that the US has, it appears to me that the Canadian economy is likely to be in for some rough sailing as our stock market crashed harder than the US, the savings rate in Canada is just as dismal as in the US, personal credit is sky high and our dollar certainly did not act like a safe-haven currency during the turmoil over the past month.

NOTEWORTHY: The economic calendar was an unmitigated disaster again last week. Retail Sales fell 1.2% in September and declined for the third month in a row. Retail Sales are now negative year over year and falling. I cannot emphasize enough that this data series along with the info on Consumer Credit are the two most important metrics in measuring the health of the global economy. And I hate to say this, but they both look deathly sick. The inflation reports – both Consumer and Producer Prices – were reported in line with expectations. I expect these data series to remain under pressure. Inflation is not a problem at this point. Wee kly Jobless Claims fell 16k last week to 461k, but it remains at elevated levels.

The Capacity Utilization dropped from 78.7% to 76.4% while Industrial production fell 2.8% and it is now declining over 4% year on year. Housing remains in dismal shape as Housing Starts and Building Permits hit new multi decade lows in September even without adjusting for population growth. Various sentiment surveys are reflecting the spread of the financial turmoil to Main Street . The New York Empire State Manufacturing Index cratered from -7.4 to -24.6 while the Philly Fed Manufacturing Index got annihilated from 3.8 to -37.5. On the consumer front, the Michigan Sentiment Survey plummeted 13 points to 57.5 in spite of crashing gasoline prices which have been supportive of consumer sentiment in the past. The Canadian economic calendar was quiet but picks up this week with the Bank of Canada Policy Meeting followed by Retail Sales and the Canadian Consumer Price Index on tap. Next week's schedule in the US will be highlighted by Leading Economic indicators and Existing Home Sales data.

INFLUENCES: Trader surveys are falling in bullishness as the market sells off. These indicators are back at neutral levels on bonds. The Commitment of Traders reports showed that Commercial traders were net long 342k 10 year Treasury Note futures equivalents – a decrease of 30k from last week. This is somewhat positive for bonds. It is interesting to note that Commercial traders have built their largest long position in the long bond futures even as open interest plummeted due to world wide de-leveraging. Seasonal influences are positive here until the end of the month. The 10 year Treasury Note yield rose sharply even as market turmoil increased the appeal of Treasury securities. The 10 year note yield traded as high as 4.10% last week, achieving our target at 4%. The view is neutral; the strategy to maximize profit is to sell straddles.

RATES: The US Long Bond future traded down over 3 points for the second week in a row to close at 113-01, while the yield on the US 10-year note increased 6 basis points to 3.93%. The yield curve was steeper and while I am retaining my steepening bias, I suggest that all my readers who made truckloads of money on this trade start lightening up somewhat at this point. I first recommended this trade when the yield curve was inverted by about 50 basis points a year and a half ago, so the 280 basis point gain is not too shabby. 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. This spread increased 8 basis points to 232 last week. I still believe the path of least resistance is toward further steepening (over 300 basis points not too far fetched) but the rubber band is getting stretched and the risk reward is certainly not nearly as attractive as it was when the 2 year yield traded below the 10 year note yield.

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

BOTTOM LINE: Bond yields jumped further, while the yield curve was steeper again last week. The fundamental backdrop is just getting worse, which is supportive for bonds. Trader sentiment is neutral, Commitment of Traders positions and seasonal influences are supportive. My bond market view is neutral.

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

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