Agency spreads narrow on Treasury rally, Fed buying; market looks past government support

By Kenneth Lim

Boston, Nov. 17 - Agency spreads tightened on Tuesday as risk-averse yield buyers came out in force, while the Federal Reserve Bank of New York supported the long end of the yield curve with more purchasing.

Bullet spreads narrowed by about 2 basis points across the curve, said Mary Ann Hurley, D.A. Davidson vice president of fixed-income trading.

"The flows were very good," she said. There were "very good two-way flows. And also, the Fed did a buyback today. That also helped as well."

Callables remained active, with step-ups still the dominant structure.

"We're seeing a lot of issuance in the step-up area, and that continues to be the case," Hurley said. "I'd say certainly not all of the deals are getting placed, but a good chunk of these securities are getting placed."

Investors across the board are getting in on step-ups, which are attractive in the current low-yield environment, Hurley added.

"I would say it's pretty much a broad spectrum," she said. "The institutional investors, banks, retail, I think some foreign buying as well."

Treasury spillover

Agencies are benefiting from current strong demand for Treasuries, Hurley said.

"Just as the Treasury market continues to improve on demand, for agencies, which are safe but more of a yield than Treasuries, the demand is there also," she said.

As Treasury yields decline, investors who want relatively safe instruments but better returns will turn to agencies, Hurley said.

"As Treasuries continue to get more expensive, people want to buy something that's safe but yields a little bit more," she said.

Looking ahead, Fannie Mae is expected on Wednesday to make a Benchmark Notes announcement. Hurley said she did not get a good sense of what the agency will do but expects a strong deal, if any.

"I'm not quite sure what type of maturity they'll come with, but their Benchmarks have generally done very well, and I would expect the same," she said.

Fed purchases seen reasonable

The Federal Reserve on Tuesday bought $1.531 billion of agency notes due 2016 to 2032, representing 35% of the $4.375 billion of notes tendered.

"I thought it was a decent buyback," said Hurley, referring to the amount that was purchased and the percentage.

Another agency analyst said the amount that the Fed bought was reasonable.

"It was OK, I thought, for the long end...$1.5 billion is not horrendously low," the analyst said.

In terms of percentages, the Fed has been reducing how much it buys in relation to the amount of notes that are tendered, but that is not a surprise, the analyst said.

"One thing you can say is they've been pretty methodical in terms of the percentages they've been taking," the analyst said. "They've had five operations that's exactly 45%, four at 42.5% and now they've done two in a row at 35%. It's obvious that they're sending the signal that they're buying less and less. I don't know how it ramps, but it could by 25% in a couple of months."

The analyst did not think that the Fed would have trouble hitting the agency purchase program's $175 billion allocation - it now has just under $25 billion to go. But the central bank could shift its focus out of the long end of the curve because of concerns that they will hold too much in the longer sectors.

"They've hit a lot of bonds at the long end at the 50% level," the analyst said. "Today they took two new bonds to 50%, and once they hit 50% they don't touch them anymore."

Post-Fed market

With a lack of drama surrounding the previous couple of Fed operations, the market is probably already looking beyond the days of the U.S. government stepping in every week to buy up agency paper, the analyst noted.

"For all intents and purposes, the program's over," the analyst said. "The market's looking past it now."

Without an obvious buyer in the market and dealers trying to shrink balance sheets, agencies will probably see some widening entering the year-end, the analyst said.

"It's hard to get too excited about year-end widening in agencies," the analyst said.

Agencies could still tighten if there is a surprising, big jump in interest rates, although the analyst does not expect that to happen.

"If you have a big rise in rates, if it did go up, then you'll inevitably see buyers of agencies, because they just become attracted to the yields," the analyst said.

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