hoye31

BondWorks

By Levente Mady / Bob Hoye

May 13, 2008

The Treasury market improved once the 10 year auction was out of the way on Wednesday of last week. There were a couple of news items that I considered to be of high importance last week. First, the news in the financial sector is not only getting worse but the time horizons on the bad news are also extending. The list of illustrious institutions that recently reported worse than expected data included UBS, Fannie Mae, AIG, Citigroup. The Citigroup news was the one that I would consider most significant. The experts tell us that the worst of the financial crisis is behind us and it appears that in recent weeks a number of negative headlines were received with a yawn or a positive reaction to support that this might indeed be the case. Citigroup announced that they plan to pare their assets to the tune of $400 Billion during the next 4-5 years. My question - not only for Citi, but for the rest of the financial sector as well – is: where will the growth come from to replace that type of contraction? Structured finance that created unlimited off-balance sheet growth is dead or mortally wounded. Lending standards have started tightening but are far from done tightening. The real economy has been hardly infected thus far. I don’t think the above mentioned contraction will be replaced at all, so I expect the financial sector to remain under pressure for an extended period of time. The other item of note was the municipality of Vallejo declaring bankruptcy. While there have been some bankruptcies in the US municipal market in the recent past, most of them had special circumstances attached to them such as derivatives poisoning a la Orange County or lost litigation in Palm Desert. Vallejo is just a plain old boring case of getting squeezed from all sides: higher operating costs from increasing energy and financing bills as well as lower revenues from rapidly declining property taxes. I would be very surprised if Vallejo was a unique case. I expect that there will be many others that are faced with the same set of issues to follow. So stay tuned for more bad news that is not as yet built into the market to follow on this front.

NOTEWORTHY: The economic data calendar was light last week. The ISM Services Index increased a couple of points to 52 for April. This indicates that the service sector is expected to increase slowly during the next 3-6 months. Pending Home Sales declined 1% in March and the February data was revised down from a decline of 1.9% to -2.8%. Needless to say, that the outlook remains bleak for housing. Consumer Credit increased $15.3 Billion last month, which works out to an annual rate of better than 7%. Personal Income is increasing at less that 4%, folks are losing their jobs but continue to amass non-mortgage credit at a 7% clip. The math does not add up. This trend will keep going until it can and then the next shoe will drop. Weekly Jobless Claims decreased 18k to 365k last week. The US Trade Deficit shrank 5.7% in spite of record energy imports. Unfortunately the decline was not driven by expanding exports; it was caused by a 2.9% drop in imports indicating a significant decline in domestic demand. Next week’s headliners will include Retail Sales, inflation reports, Housing Starts, and more sentiment surveys on the manufacturing and consumer fronts.

INFLUENCES: Trader surveys were back to neutral on bonds during the latest week. The Commitment of Traders reports have indicated that the commercials have a long bias in their positioning. Last week’s data indicated that Commercial traders were net long 371k 10 year Treasury Note futures equivalents – a decrease of 3k, which is supportive for the bond. Seasonals turned positive. The 10 year yield held support in the 3.9 to 4% area to hold for now. The positive factors are increasing, so I expect a bullish bias to persist here.

RATES: The US Long Bond future traded up a point to close at 117-08, while the yield on the US 10-year note decreased 8 basis points to 3.77%. The yield curve was steeper and I am expecting that the curve will trend to steepening. 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 moved up 15 bps to 155 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 bond spreads rallied sharply again. 10 year bank sub-debt spread moved in another 40 basis points to close the week inside 200. I recommended shorting the bank sub-debt issue at Canada bonds +58 basis points a while back. A couple of weeks ago I recommended that accounts review their short exposure and fine tune it somewhat by covering half the short position. As per the comments above, I don’t think we are out of the woods yet on fixed income spread product yet. We are seeing record corporate issuance across the spectrum. New product is well received and it is narrowing in. I hope this temporary recovery has a bit more strength, so we get a chance to reset the shorts we covered last month.

BOTTOM LINE: Bond yields moved lower across the yield curve lead by the short end. The fundamental backdrop remains bleak as the economic data just keeps getting worse. That is positive for bonds. Trader sentiment is neutral, while the COT positions and seasonal influences are supportive. My recommendation is to add to the curve steepener, continue to shun the weaker corporate credits. The market tested support at 2.50% on 2 years and 3.90% on the 10 year note. Both these levels held the line in the sand and have the potential to head lower at this juncture. My bias remains bullish.

bobhoye@institutionaladvisors.com

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