Shorter agency spreads tighten on light volumes; Fed seen behind schedule on agency purchases

By Kenneth Lim

Boston, Aug. 14 - Agency spreads tightened slightly on the front end on a quiet Friday as the Federal Reserve's weekly purchasing program was smaller than usual.

Bullet spreads on the front end were tighter by about 1 basis point or so, "nothing particularly dramatic," said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott LLC.

"Swaps moved out a little...4 to 5 bps wider on the front end," he said.

Market volume was light as trading slowed to a crawl in the afternoon.

"It is a summer Friday," LeBas said. "Some of the shops were closing around noon...Not a lot of new issue deals coming to market today."

The most active bullets were two- to three-year paper, according to data provided by Tradeweb. Spreads on the Federal Home Loan Banks 1.625% notes due July 2011 ended wider by 0.4 bps at 15 bps, while the Fannie Mae 1.75% notes due August 2012 ended unchanged Friday at 27 bps.

Fed buy-up smaller than usual

The Federal Reserve Bank of New York on Friday said it bought $1.784 billion of agency securities on the open market, representing about 40% of amounts submitted.

The notes targeted were in the four- to seven-year sectors, maturing from 2013 to 2016.

"This is actually the smallest [open market operations] in this agency sector," Cantor Fitzgerald head of fixed income rates strategy George Goncalves said in a note.

Goncalves noted that the Fed's agency purchases appear to be slowing down, and the purchasing program is actually behind schedule.

"The Fed's run-rate has been running at a slower pace for GSE debt purchases and is not poised to purchase the potential $200 billion total (will end up with $150 at the current pace)," he wrote.

Investors could have benefited from the Fed's buying of five-years with trades in the belly of the yield curve offering a better risk-reward profile, Goncalves wrote.

"As agencies in general have been underperforming swaps for the better part of the last five days, this could be used as a perfect opportunity to re-shuffle positioning," he wrote.

Janney Montgomery Scott's LeBas said the slower purchasing could be due to the Fed having problems finding enough sellers.

"The Fed has had a little bit of a challenge in finding sellers to pick up all the $200 billion that they're looking for in agencies," LeBas said. "The $300 billion goal for Treasuries is for October, but I think that puts pressure on the agencies program...I think the two are very much related."

Part of the problem for the Fed is that its goal in the agency market is relatively more substantial than its other targeted markets in Treasuries and mortgage-backed agency securities.

"The $200 billion goal for agencies, compared to the $1.25 trillion for mortgage-backed securities and $300 billion for Treasuries, represents a much larger portion of the agency market," LeBas said. "There's just this one massive buyer, and they're having trouble purchasing."

The Fed is likely to complete the purchasing program rather than let it run out without buying up the full $200 billion, so an extension of the agencies program, as was done with Treasuries, could be possible, LeBas added.

"I think they're more apt to do the whole amount...They might extend it," he said.

Look out for callables, three-years

LeBas said the week ahead could be even quieter.

"Big vacation week, not going to be a lot going on," he said.

Banks do appear to have quite a bit of cash waiting to be put to use, which could benefit some callables, he added.

"A lot of bank buyers with cash on the sidelines...could look at the five-year/one-year callables, which is a pretty popular bank sector," LeBas said.

Barclays agency analysts Rajiv Setia and James Ma highlighted recent cheapening in three-year bullets as an opportunity, according to a research note.

"We would recommend taking advantage of the recent cheapening in 3s - the tenor offers little to no give-up to most five-year issues at about T+30 bps, as well as considerable rolldown into the two-year sector," the analysts wrote.

The Barclays team also expects issuers to continue offering double-digit concessions on new deals, as was done during the week when Fannie Mae priced $3 billion of five-year Benchmark Notes at a spread that was about 11.5 bps over secondary market levels.

"However, given a backdrop where net issuance remains solidly negative and Fed demand fairly persistent, with about $90 bn in purchase program capacity left, a further blow-out in spreads is unlikely," the analysts wrote.

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