Agency spreads unchanged ahead of employment data; Fed's on-the-run buying gets mixed reviews

By Kenneth Lim

Boston, Sept. 3 - Agency spreads withstood early widening to end unchanged Thursday as investors awaited employment data, while the Federal Reserve Bank of New York completed its weekly purchasing operation.

"Spreads have remained fairly quiet, and we're seeing two-year [Federal Home Loan Banks] about 15 basis points over Treasuries, three-years at 24 bps, five-year Fannie Mae 3%s of September 2014 at plus 37 bps," said Christopher White, senior vice president of sales and trading at Moors & Cabot Capital Markets. "We've seen a little bit, in credit, of flight to quality trades in the middle of the week this week, but it didn't really affect agency debt that much."

The market was mostly quiet with the typical summer lull as the Labor Day weekend looms. But investors were also waiting to see how Friday's non-farm payroll numbers will turn out, White said.

"The big number obviously tomorrow is employment...We have a big day tomorrow, and it's going to be kind of interesting," he said. "Volume ratcheted down this afternoon."

Fed buys on-the-runs

The Fed on Thursday bought $3.779 billion of two- to four-year agency notes through its open-market operations, about half of the $7.558 billion offered.

About half of the notes purchased came from on-the-run securities - $1.078 billion of the Fannie Mae 1.75% notes due August 2012 and $863 million of Freddie Mac 2.125% notes due September 2012. Those purchases were the first that targeted on-the-run agency notes since the buying program started.

The market appeared to be mixed about the latest operation.

"I thought the action from the Fed was fairly aggressive, but there were sellers," one agency trader said. "We expected it to be busy and it was."

White said the deal "basically came and went" and "it didn't affect the curve at all."

"That's right where we expect the buyback to be at," he said.

The Fed's decision to expand its purchasing program to include on-the-run securities has given a boost to confidence about the likelihood that the central bank will finish buying up all the $200 billion of agency securities that it is allowed to purchase, White added. The bank has now bought about $120 billion of agency notes.

"Right now the market perceives it as on schedule, and so in my opinion, if as we go through the buyback process, if the Treasury says we're not going to buy as much, that could cause spreads to widen."

But George Goncalves, chief fixed income rates strategist at Cantor Fitzgerald & Co., said the amount that was bought on Thursday was less than he expected.

"This drops the purchase pattern in the front-end back to average, which is odd given how a large part of today's purchase was with the larger new on-the-runs," he wrote in a note.

But on-the-runs will continue to be a key target of future Fed actions, he added.

"Going forward, we should expect (as it is with [U.S. Treasury open-market operations]) whenever there are large new issue bullets up for offering, the Fed purchases should target on-the-runs," Goncalves wrote. "This will over time help improve (or stop taking away) some dis-liquidity that has been hampering off-the-run agencies."

Eyes on supply

While there is a lack of major economic data in the week ahead, Treasury auctions in the three-, 10- and 30-year sectors could put pressure on rates markets in a holiday-shortened week, White said.

"It's not a big week with regards to economic statistics, but the supply on the short week will be a little challenging," he said.

The Treasury will auction three-year notes on Sept. 8, followed by 10-years the next day and 30-years the day after that.

The markets after Labor Day could see quite a bit of uncertainty, White added.

"If you've locked in a fairly positive year you could say I'm done," he said. "Or, and I think this is more likely what's going to happen, you're going to see the fixed market look at the equity market. The equity market looks like it's a little toppy, it's ahead of the economy right now, and you could see the fixed market react to that."

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