Agency spreads tighten as Fed buys $1.8 billion in long end; Fannie Mae to announce Thursday

By Kenneth Lim

Boston, Oct. 21 - Agency spreads tightened slightly on Wednesday with the Federal Reserve providing key support further out on the yield curve.

Meanwhile, Fannie Mae is expected to announce on Thursday a deal at the front end or that it will pass on its next scheduled Benchmark Notes issuance, market sources said.

"Spreads were 1 to 2 basis points tighter today," said Thomas L. di Galoma, head of U.S. fixed income rates trading at Guggenheim Capital Market. "They've just been continuing to tighten."

Volumes in general were relatively light.

"It was pretty anemic," di Galoma said. "We only saw some '17s come in from overseas, and it looks like they might have gone to the Fed."

Another trader acknowledged that the agency market has been dull so far this quarter.

"First of all spreads are extremely tight at the short end, so it's not really an exciting space at the moment," the trader said. "Investors are buying on dips, but that doesn't happen all the time. The other thing is, it's something that's over-said but it's still true, a lot of investors are standing on the sidelines waiting to see if the stock rally's got legs."

Still, callable issuance remained vibrant as investors continued to seek better-yielding step-up structures.

"In a low-yield environment investors are attracted to step-ups for the potential of higher yields," the trader said. "At the same time, a lot of off-the-run stuff has been called, so a lot of the issuance that we're seeing is simply the agencies reissuing debt at lower rates."

Fed buys at long end

The Federal Reserve Bank of New York bought $1.76 billion of seven- to 23-year agency notes on Wednesday as part of its outright agency coupon purchase program.

The amount that was bought represented about 42.5% of the $4.142 billion of securities offered.

Di Galoma said the Federal Reserve, which buys agency debt from the market through the New York bank, has been playing a significant role in pulling spreads inwards.

"The Fed expanding its role in buying those out until March, it's caused them to just continue to tighten in," he said. "The low volatility environment that we're in as well is just tightening them in."

But the second trader said the actual buying on Wednesday was not a major factor influencing the day's spread movements.

"I think what usually happens is the affected sector will tighten slightly when they announce the buybacks, which is usually the day before the buyback itself," the trader said. "The impact on the day of the buyback itself is minimal, unless they buy more than expected."

George Goncalves, chief fixed income rates strategist at Cantor Fitzgerald, was expecting a light operation from the Fed because the central bank on Wednesday also bought longer-end Treasuries in another open-market action.

"The Fed just conducted a [U.S. Treasuries open-market operation] in the back end and purchased less than expected," Goncalves wrote in a note. "We should see a repeat at this agency OMO pass as the Fed is draining a decent amount of duration out of the market today."

Fannie Mae may pass

Fannie Mae could announce a reopening at the front-end of the curve or skip an issuance altogether on Thursday, the trader said.

The mortgage agency, which sold $5 billion of new two-year 1% Benchmarks on Oct. 8, is scheduled for an announcement on Thursday.

"They just did a two-year, they re-opened five-years in September, reopened three-years in August," the trader said.

"I think they're going to pass like they did in June because they don't really have any funding needs right now. I know some guys think they might do something in three-years, which they haven't really issued new three-years since July. I'm not counting reopenings. But even if they offer new three-years, I don't expect them to sell a lot."

A Fannie Mae announcement in the three-years could put some widening pressure on spreads in that sector, the trader said.

"That's usually how it goes," the trader said. "But there's so much demand for these on-the-runs right now I don't know if it's going to make that much of a difference."

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