Agencies narrow as bargain hunters target front end; Fannie Mae sees demand for two-years

By Kenneth Lim

Boston, Aug. 26 - Agency spreads tightened slightly at the front end on Thursday as Fannie Mae saw strong initial demand for an offering of two-year Benchmark Notes.

Bullet spreads narrowed versus Treasuries in the two- to five-year sectors on the strength of a quick start, although the longer part of the yield curve underperformed, an agency trader said.

"We closed the day on a quieter note after a busy morning," the trader said. "In general, three- to five-year paper outperformed Treasuries and swaps a little bit."

The front-end rally was welcome relief after the market widened for most of the week. The cheapening over the past few days may have attracted some buyers back to the market, the trader said.

"We've seen some better selling over the last few days, and the back-up in yields offered some investors and traders an opportunity to come in and cover some shorts and buy back some paper," the trader said.

Callables have been a little quieter this week, but Thursday saw a decent amount of issuance. Shorter-term deals have been dominating the primary market because of a recent improvement in returns.

Fannie Mae launches two-years

Fannie Mae plans to price new two-year Benchmark Notes on Friday, with price talk set at 18 basis points over Treasuries, market sources said.

The size of the deal has not been set, but it is expected to be at least $3 billion. The trader said the order book was said to be $5 billion heading into the close Thursday.

"We saw demand right out of the gate...and the books look good going into the overnight session," the trader said.

Barclays Capital Inc., Goldman Sachs & Co. and J.P. Morgan & Co. are the lead managers.

The price talk represented a spread of 1 bp below Libor, which was relatively attractive, the trader said.

"The whole sector is cheap," the trader said. "Given the low yield at the front end and the inability of agencies to tighten further against Treasuries, agencies have consequently widened versus swaps."

The announcement may have caught some market observers by surprise, with a number of sources saying that they had expected a small reopening or a pass by Fannie Mae.

"At minus 1 bp to swaps level in that sector, I didn't think that they had the need or the want to issue at that cheap funding level," the trader said. "They get a lot better levels in shorter discount notes and further into three-years. But I think they probably had to put out something in that maturity."

Two-year spreads did not widen much on the news, but that may not necessarily be an indication that the market saw the announcement coming.

"It's jammed up with yields so low there, any half or 1 bp move is percentage-wise much larger than further out the curve," the trader said. "If anything we saw two-year spreads firmer, but I'll call them unchanged."

Lagging week

The market is likely to go out weaker than when it began, the trader said.

"Accounting for the fact that we had a 2 bps two-year roll and a 3.5 bps five-year roll, right now in the two-year sector spreads are about 2.5 bps wider versus Treasuries," the trader said. "In three-years we are basically unchanged to 0.5 bp wider, five-years about 1 bp wider, and 10-years are significantly wider."

Most of the widening in the three- to five-year sector came at the start of the week, when disappointing housing data sparked a flight of money out of spread products.

"I wouldn't call it a blowout because it was only 3 to 5 bps, but there was definitely a widening in the three- to five-year sectors," the trader said.

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