Agency spreads flat as volume increases on quarter-end trading; Fed to extend buybacks

By Kenneth Lim

Boston, Sept. 23 - Volume in the agency markets picked up on Wednesday, although spreads ended mostly flat again with investors getting what they were expecting in the Federal Reserve's announcement on the economy and the open-market purchasing program.

Bullet spreads closed mostly unchanged for the third day in a row with the market reluctant to make a clear move in any direction, market sources said.

"We're kind of at the mercy of the shape of the curve right now," an agency trader said. "The front end doesn't really have anywhere to really go, but we kind of steepened out at the end of the day.

Overall volumes picked up as dealers approached the end of the quarter.

"This time of the month, heading to the end of the quarter, we're seeing pretty good two-way flow," the trader said. "There's pretty good buying in the callable space. But it's the same story. The Fed came and announced the results of their meeting, and we're off to a race yield-wise, which takes out all the rate buyers."

The currently tight spreads in the agency markets are affecting the amount of interest from investors in the asset class, the trader said.

"I keep running into accounts who are looking at the yields and saying agencies are too rich," the trader said. "It's tough right now when we keep getting these run-ups."

But the market could be poised for even more tightening, the trader said.

"Just yield-wise it's set up for prices to go higher," the trader said.

Agency investors will also be looking toward a possible offering of Reference Notes by Freddie Mac on Thursday. The trader was expecting a sale of two-year notes, if any.

"That would soften things up a little bit if they come with a deal," the trader said.

Fed does not surprise

The Federal Open Market Committee will extend the deadline for its agency debt purchasing program to the end of the first quarter in 2010 while maintaining the target size of the program at $200 billion, according to a statement by the central bank on Thursday.

The Fed has already bought about $125 billion of agency paper under the open-market operations, which were initially scheduled to end Dec. 31, 2009. Its $1.25 trillion agency mortgage-backed securities buying program will also be extended by three months to the end of the first quarter of 2010.

"The committee will gradually slow the pace of these purchases in order to promote a smooth transition in markets and anticipates that they will be executed by the end of the first quarter of 2010," the Fed statement said.

The announcement was already mostly priced in by the market, sources said. The trader said "it's going to obviously benefit spreads the longer they maintain it," but the net effect should be negligible.

"It's like a stock split where you get double the shares but at half the price," the trader said. "Now they're extending it, but the amount is going to be kept at $200 billion, so it's a little bit of a non-event."

An agency analyst agreed that the news should not be a surprise.

"The fact that they addressed it was widely a consensus view, and the way they addressed it was pretty darn close to consensus," the analyst said. "Spreads didn't really do much in the agency market as a result of that. We're pretty much unchanged on the day-to-day in terms of spreads over Treasuries."

New GSE landscape in play

The analyst said the market had mostly priced in the expected exit of the Fed eventually from the agency market, although the Fed has itself some wriggle room if it has to expand the program. The bigger concern would be how the U.S. government decides to restructure Fannie Mae and Freddie Mac in 2010.

"My feeling is the market is not going to be surprised by the Fed's exit," the analyst said. "Where the surprise lies is in the structure of the GSEs going forward."

The Treasury is expected to report in 2010 at the time of the budget announcement its plans for the new structure of the government-sponsored enterprises, but "it's not at all clear what's going to be on the report," the analyst said.

"I personally don't think the GSEs have any idea what's cooking either," the analyst said.

The agencies have been cutting down on their debt issuance as they prepare to pare their portfolios in 2010, and the supply picture could change dramatically when the issue becomes clearer, the analyst said.

"There are very big potential forces at play for agency debt going forward, and the biggest is supply," the analyst said.

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