Agency spreads flat as Fed buys at short end; callable issuance picks up on retail demand

By Kenneth Lim

Boston, Nov. 23 - Agency spreads were mostly unchanged on Monday as the Federal Reserve Bank of New York stepped in to boost the front end of the yield curve.

Bullet spreads were flat to slightly tighter, said Christopher White, senior vice president of fixed income sales and trading at Moors & Cabot Capital Markets.

Federal Home Loan Banks 1.625% notes due November 2012 closed at a spread of 21 basis points over Treasuries, "essentially unchanged," White said. Closing a tad narrower were Fannie Mae 2.625% notes due November 2014 at a spread of 27.75 bps and Freddie Mac 3.75% notes due March 2019 at a spread of 33 bps.

"Obviously a short week," White said. "Really the only thing I focused on was the buybacks earlier today."

The rest of the week is expected to be quiet as well, with no major bullet offerings expected until Nov. 30, when Freddie Mac will make an announcement on Reference Notes.

"I would expect people to close books on Wednesday, and Wednesday will be skeleton staff, and Friday as well," he said.

Fed buys at short end

The Fed on Monday bought $2.017 billion of two- to four-year agency notes, representing 35% of the $5.763 billion tendered.

The purchased-to-tendered percentage was similar to the previous week's operation, and so it did not create any surprises for the market, White said. But questions remain unanswered about how the market will behave when the Fed stops its purchase program after the first quarter of 2010.

"It's become such a norm that the Fed buybacks will bail you out, but when...they stop, who's going to buy the debt?" White said. "Of course banks are flush with cash right now because of support they're getting from the Fed, so they'll be able to come in and buy agencies."

One risk lies with the foreign central banks, which could start to move out of agencies when they can get better yields elsewhere, White said.

"Certainly if the dollar continues to get devalued, foreign central banks will lose interest in agency debt...if they can get better yields elsewhere they will, but that hasn't happened yet, and I don't know when that will happen," he said.

Cantor Fitzgerald chief fixed income rates strategist George Goncalves also thought that the purchased-to-tendered percentage was "reasonable."

The latest operation was spread among a broad swath of notes, Goncalves wrote in a note. Looking at how much the Fed now holds, there could be opportunities in some older issues where the Fed has more room to purchase in the future, he added.

"The old two through three-year issues are on the cheap side especially if U.S. Treasuries catch a bid again," he wrote. "There are many issues in that area of the curve where the Fed owns less versus down in the one- to two-year sector."

Callable wave

Monday was a strong day for callable issuance, White said.

"We had probably a total of about 45 different prints in new issues on the retail end, which is a lot," he said.

The surge is a response to strong demand for callable structures, especially step-ups, amid the current low interest rate environment, he explained. Money market yields currently hover at around 0.20%, and investors crave better returns than that.

"You're seeing a lot of retail basically not earning any money in money markets and so they're extending out the curve and buying agency debt," White said.

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