Weekly Wrap-Up August 24-28, 1998

Closing Numbers

The North American bond markets felt that time tested and true "flight-to-quality" trade take hold again this week. The Canadian bond market was treated as very liquid spread product versus the US, and sold into the week's end. The US market established a record low yield as financial concerns from around the globe placed the US bond and currency market as the only safe haven for capital this week.

As the Canadian dollar continued to set new lows versus the American dollar, and the Asian currencies meandered in their distressed situations, the Russian government first suspended the convertibility of rubles into American dollars, and then finally suspended the currency's convertibility altogether. As well, the Russian government converted its 1 year T-bill obligations into 5 year debt obligations, effectively defaulting on its current debts. This did little for all markets save the US bond and currency markets.

In response to the ailing Canadian dollar the Bank of Canada felt it could no longer ease the currency's decline through mere FX market intervention. The effects of buying Canadian dollars and selling US dollars in the open market did little to slow the Loonies fall. Ergo, the Bank of Canada raised short-term interest rates 100 basis points, to 6%. This pushed the major banks in Canada to raise their prime lending rate to 7.50%. In an interesting article presented this week the prediction was made that the raise in interest rates will push Canada into a recession in the next 12-18 months. Concern exists on the street in Canada as to what the Bank of Canada will do if the currency continues its retreat vis-a-vis the $US. Having already raised interest rates 100 basis points at time when unemployment remains high, inflation is non-existent, and the economy appears to be slowing as a result of the Asian and Russian turmoil, how high can interest rates be raised before there is a recession in Canada? The Bank should not have raised rates to defend the dollar, as the long term trend is still lower. Are we having fun yet?

Economic data had no effect on the bond markets whatsoever this week. With the global melt down in the equity markets, and the continued depressed prices for global commodities, there was little reason for the bond markets to fear a surge of inflation. Fundamentals were literally abandoned in the bond markets as fear drove many investors to sell their holdings in anything that was not denominated in US dollars, and have the full support and guarantee of the US government.

As for the economic numbers released this week, few were even looked at. In the US consumer confidence for August declined 4.1 to 133.1; existing home sales rose 4% in July; durable goods rose 2.4%; US second quarter GDP rose 1.6%, with the price inflator rising 0.8%; personal income grew 0.5%, with personal consumption declining 0.2% in July. In Canada, net foreign investment in June rose $Cda 414 million; industrial prices rose 0.3% in July; raw materials increased 0.3%; average weekly earnings rose 0.8% in June on a year-over-year basis, while they declined 0.2% month-over-month.

The Canadian 30 year bond added 17 basis points to its yield this week, to close at 5.81%, as it significantly under-performed the US market. Domestic and foreign accounts alike were sellers of the Canadian bond market in an attempt to preserve capital in a turbulent market. The Bank of Canada came to the market with $Cda 2.3 billion new 5 year bonds, which went reasonably well in auction, but were soon underwater, with many dealers on the street caught long the bonds as the market sold off. In the US, the "flight-to-quality" panic exhibited by the global market place saw the 30 year Treasury bond shed 12 basis points, closing the week at a record low yield of 5.34%. This is the lowest yield the US 30 year Treasury bond has had since it was originally issued in 1977. The Canada/US 30 year spread has pushed considerably wider as a result of the international financial concern, closing the week at 47 basis points. (A basis point is 1/100th of a percent.)

The North American equity markets felt the upheaval of the world financial melt-down this week. No exchange was spared the carnage. As the economies of other nations slowly collapse, there will be little in the way of demand for goods and services, thereby limiting corporate earnings and profits. As the earnings picture erodes, so to must the values assigned to those earnings. Perceptions of future earnings were hit hard this week as markets shed a significant amount of their values. Countries which have predominantly commodity driven economies continue to be hard hit. Australia and Canada are two of the most notable.

The melt down in the equity markets was accompanied by continued weakness in commodity prices. Three oil producing countries scheduled to meet this week to discuss the current price of oil cancelled their meeting, driving the price of crude oil lower. Presently you can buy a barrel of oil in July of 1999 for under $US 15.50, including storage. Cheap, cheap cheap. As there is no inflation to need to have a store of value against, and concerns are mounting that the Russian central bank will be forced to sell significant quantities of gold in an effort to defend the ruble, gold continues to fall. This week closing at a 19 year low of 274.60. Combine these factors with the Bank of Canada's 100 basis point rise in interest rates, and there was little for the market to do but sell, and sell, and sell some more.

The TSE finished the week down 527.97 points, or 8.39%, at 5766.31. Banks, industrials, mining, and metals all helped sink the exchange. In the US, markets fared little better as banks announced losses from trading operations would be significant. The DJIA slipped 481.97 points, to close the week down 5.56%, at 8051.68. The S&P500 lost 5% of its value, while the Nasdaq lost 8.79%. Year to date the TSE is down almost 14%, and the DJIA has lost almost 2%. When looking at it from the recent highs, the numbers are significantly worse. There has been a greater than 10% correction in the North American equity markets, is the bear loose?

With markets providing little in the way of profitability for the trading houses, if you take away initial public stock offerings and debt underwriting income as well, the earnings for the next few quarters look shaky. There is more to be concerned about with the banks over the near term, which includes bad debt provisions, and exposure to the derivatives market. With three hedge funds in the US seeking bankruptcy protection this week, there are a lot of leveraged deals out there which may unwind more than just a trading desk or two.

Look for a little calm next week if the Russian government can show some semblance of stability, particularly if it appears not to be headed back to a planned socialist economy. The free market experiment has not failed completely, only had a set back requiring some regulation to mitigate the current corrupt short -comings of the Russian system. The Canadian dollar rebounded nicely off of its lows on Friday, but many wonder if it was just a short covering rally, while traders get ready to set up new short positions. The Loonie has to have a period of sustained stability before any real strength will emerge in the Canadian bond and equity markets. The current "flight-to-quality" trade has the US bond market looking expensive and should trade back down to the 5.50% range. If the international markets still look to be volatile it will be later, rather than sooner, that the US reaches that level on long bond yields. Good trading.

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