Agency spreads tighten as Fed expands purchasing program; Freddie Mac reopens three-year notes

By Kenneth Lim

Boston, Sept. 1 - The new month began on a positive note as agency spreads tightened as the Federal Reserve said it was expanding its purchasing program to include on-the-run securities.

Meanwhile, Freddie Mac's reopened three-year Reference Notes saw strong response in an auction to price at a yield of 1.772%.

"The agency markets [had] a little bit of a good feeling today," said Janey Montgomery Scott LLC chief fixed income strategist Guy LeBas. "Spreads in the three-year area came out a little wider with the issuance, but it was tighter everywhere else."

The bid spread on the Federal Home Loan Banks 1.625% notes due July 2011 came in by about 1.3 basis points, according to data from Tradeweb. Bids on Freddie Mac's three-years widened by about 2 bps, while those on Fannie Mae's 3% notes due September 2014 contracted by about 0.5 bps.

Freddie Mac sells well

Freddie Mac sold $1 billion of its 2.125% Reference Notes due September 2011 on Tuesday to yield 1.772% through an auction.

The bid to cover ratio was 4.33, according to data from Freddie Mac. The spread was about 29 bps at pricing, a market source said.

The amount outstanding under the series is now $5.5 billion.

The deal came within market expectations that called for a deal in the short end of the yield curve and follows Fannie Mae's $1 billion reopening the previous week of its three-year 1.75% Benchmark Notes.

The deal received good interest largely because of the market's expectation that the Federal Reserve will be buying short-end paper, LeBas said.

"With Fed interest in those shorter maturity items, we certainly saw dealers taking down blocks with the expectation of selling to the Fed later in the week," he said.

Fed will buy on-the-run paper

The Fed also said its weekly open-market purchasing program will be expanded to include on-the-run agency securities.

The central bank had initially only bought off-the-run agency debt in its weekly operations. The Fed has bought about $117 billion of the $200 billion allowed under the program, which ends at the end of the year.

"This change represents a technical adjustment designed to mitigate market dislocations and to promote overall market functioning," the Fed said. "Over the course of the program, the Federal Reserve may change the scope of purchasable securities."

The move did not come as a surprise, LeBas said.

"The Fed's had a hard time finding enough agencies to buy with the $200 billion program," he said.

The move may not lead to more issuance by the agencies, he added.

"Right now actually there's not a lot of consumer loan demand," LeBas said. "Everyone's deleveraging. Consumers are deleveraging, which affects Fannie Mae and Freddie Mac, and the banks are deleveraging, which affects Federal Home Loan Banks. Issuance will be constrained by that."

George Goncalves, head of fixed income rates strategy at Cantor Fitzgerald & Co., said the Fed's move was probably a recognition of the weekly purchasing program's effect on the market.

"I think there's a realization that a lot of the off-the-run securities were bought in a very big way, and if you keep buying them you're going to become the market," he said, adding later: "You have to think about your footprint, right? Everyone talks about the carbon footprint, well, now the Fed has a footprint in the market. They're realizing they can't keep taking away off-the-run securities."

The expansion of the program could help to loosen liquidity in off-the-run paper, Goncalves said.

"I think it's meant to improve liquidity or to stop taking liquidity away from the off-the-runs," he said. "Hopefully it will help off-the-runs find some stability."

In terms of spreads, the market now has more than just the Fed buying on its mind, he noted.

"Spreads have been so tight," he said. "At this point spreads are no longer at the mercy of Fed purchases but at the mercy of the overall developments in the credit landscape...I think credit has had its year. It's going to be tougher going forward. Thus it's going to be harder to pick up total return in agencies going forward as well."

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