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Government Bonds Strong Rally on Grim Economic Outlook

Interest-Rates / US Bonds Oct 06, 2008 - 03:17 AM GMT

By: Levente_Mady

Interest-Rates Best Financial Markets Analysis ArticleThe bond market traded up last week as panic in financial markets intensified. The latest and greatest $700 Billion bailout package was finally passed by the US authorities last Friday, but it did not seem to make much difference as stocks dropped another 3-4% once the deal was officially passed. As previously mentioned in this here column, it is just another band-aid that hopes to provide quick relief for the symptoms of this gigantic financial crisis without addressing the real problem of dealing with the excess credit that has been built up on all fronts. European governments have also been busy with various rescue plans. Ireland and Germany are leading the charge by declaring that those governments now will guarantee all deposits in their respective banking systems. Surely other countries, including the US , will not be far behind adopting this drastic measure.


The chatter is getting louder about expectations of lower Central Bank rates. The market is now looking for imminent rate cuts from the Fed, and even old JC (Trichet, of the Euro Central Bank) started hinting for the first time in many moons that his organization might be inclined join the party to lower official rates.

Well, if this crisis is not front page news by now, I am not quite sure what is. All of the sudden the taxi drivers and shoeshine boys, waiters and barbers are all becoming experts about Libor, Credit Default Swaps and the long list of financial acronyms that are blamed for the current crisis. What I am wondering about is if those newly found experts are in as much of a hurry to pay down their credit card balances, auto loans or other debts that they might have as they are to offer their worthy opinions on how to solve this crisis. With all the hooting and hollering, I can't help but think that a temporary bottom in the stock market may not be too far from here. That should be negative for the Treasury market in the short term.

NOTEWORTHY: The economic calendar had more bad news to bear. The financial mess is having an increasing impact on economic activity and the latest slew of data has more evidence to support this fact. Auto Sales remained extremely weak in September. The auto industry is getting squeezed on a number of fronts. Consumers are finding out that financing (either from the manufacturer or from financial institutions) is becoming increasingly difficult to come by. The cost of financing is also becoming more difficult and much more expensive for both auto dealers and manufacturers. With bleak prospects in the job market, qualifying for auto loans will not become any easier. Construction Spending was flat in August after back to back declines of 1.4 and 0.2%. The ISM Survey of Manufacturing Purchasing Managers “unexpectedly” declined from 49.9 (neutral) to 43.5 (recessionary). As a confirmation of the ISM Survey results, Factory Orders declined 4% in August.

Weekly Jobless Claims rose 4k last week to 497k, as it remained within a whisker of 500k for the second week in a row. The Monthly Employment report showed increasing weakness on the labour front. Non-farm Payrolls declined 159k in September, while the official Unemployment Rate managed to stay unchanged at 6.1% due to fewer people bothering to look for employment. Just to put things in perspective, a net of 1 million employees lost their job and an additional 2 million available folks could not find employment during the past 12 months in the USA . The Service Sector Purchasing Managers' Survey held steady at a neutral 50.2 reading. The Canadian economic data was stunningly strong in the global context. GDP increased 0.7% in July, bouncing back from a flat first 6 months in 2008. Industrial Production jumped 2.2% during the same period north of the border. This data is unfortunately quite out of date and prospects of further strength are rather dim. Next week's reports will be highlighted by reports on Consumer Credit, Pending Home Sales and the August Trade deficit.

INFLUENCES: Trader surveys are back at neutral levels on bonds, as they have moderated over the past weeks. The Commitment of Traders reports showed that Commercial traders were net long 356k 10 year Treasury Note futures equivalents – an increase of 24k from last week. This is slightly negative for bonds. Seasonal influences are turning sharply negative here. The 10 year note yield dipped temporarily as month/quarter end window dressing and financial market turmoil increased the appeal of Treasury securities even at these skimpy levels. Once these influences are out of the way, my view remains slightly negative; I expect the 10 year note yield to head back up toward 4%.

RATES: The US Long Bond future traded up over 2 points to close at 119-20, while the yield on the US 10-year note decreased 26 basis points to 3.60%. The yield curve was steeper and I am retaining my 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. This spread increased 27 basis points to 202 last week.

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

BOTTOM LINE: Bond yields dropped sharply, while the yield curve was steeper again last week. The fundamental backdrop is grim, which is supportive for bonds. Trader sentiment is neutral, Commitment of Traders positions are slightly supportive, but seasonal influences are quite negative. The recommendation is to invest in the 2 year Treasury and Canada bonds, and to shun the weaker corporate credits. I am expecting the 10 year Treasury Note yield to drift back up toward 4%.

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

The data and comments provided above are for information purposes only and must not be construed as an indication or guarantee of any kind of what the future performance of the concerned markets will be. While the information in this publication cannot be guaranteed, it was obtained from sources believed to be reliable.  Futures and Forex trading involves a substantial risk of loss and is not suitable for all investors.  Please carefully consider your financial condition prior to making any investments.

MF Global Canada Co. is a member of the Canadian Investor Protection Fund.

© 2008 Levente Mady, All Rights Reserved

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