Agencies widen on safety flight as analysts cut global view; European bank troubles eyed

By Kenneth Lim

Boston, Aug. 18 - Agency spreads widened Thursday as dimmer outlooks for the global economy sent investors rushing for safe-haven Treasuries.

Bullet spreads closed the day about 2 basis points wider versus Treasuries in the two- to three-year sector, while longer maturities widened by half to 1 bp. Fannie Mae's new 1.25% Benchmark Notes due 2016 widened by about 2 bps to a bid spread of 35 bps over Treasuries.

"It was a wild day today marketwise," an agency trader said, adding that "right out of the gates bids were getting hit."

The callable market was also quieter as investors experienced sticker shock on the drop in yields.

"There wasn't as much issuance as the past few days," the trader said.

Yields fall to record lows

Yields dropped following renewed worries about the global economy and Europe's debt crisis. The 10-year Treasury yield reached a record low of about 1.99% at one point in the day, 4 bps lower than the previous record, which was set earlier in the month.

Morgan Stanley on Thursday cut its outlook for global economic growth to 3.9% from 4.2% and warned that Europe and the United States were "dangerously close" to another recession.

The bank, however, added that it did not expect a recession, if there is one, to be as crippling as the one that struck in 2008.

There were also reports that a bank had borrowed $500 million from the European Central Bank and that the U.S. Federal Reserve was concerned enough about the euro zone debt crisis to hold discussions with European banks that have U.S. operations.

"The biggest concern right now is the sense of a self-fulfilling prophecy," the trader said.

If negative headlines continue to erode confidence in European banks, that might drive the costs of funding and collateral up for those banks, and force them to seek aid they may otherwise not need, the trader said. Investors are also trying to figure out which banks are the most vulnerable.

"The market's picking out a victim, and we don't know who the victim is going to be, but the market's going to press the pressure points until it figures out what the entity is," the trader said.

Thursday's dramatic flight to quality overwhelmed investors once the markets opened.

"A friend of mine, who trades callables on a very big desk, sent me a message that said, 'I'm scared,'" the trader said.

Late resistance

The market appeared to calm down late in the day, as spreads came in slightly, especially after the 10-year Treasury yield hit 2%.

"People were asking, hey, what's happening here?" the trader said.

Investors remain concerned about the report of a European bank having to borrow money from the ECB.

"If Swiss banks are borrowing, for example, that's not a bank from Spain or Italy or Greece," the trader said. "If Swiss banks are borrowing, that's a little unnerving."

But yields may need a stronger push if they are to go lower, the trader said.

"At the end of the day, with stocks down 420 or so, it felt like after that move through 2% today...when stocks bounced midday and went back down to 400 but bonds didn't rally, it suggests to me that this bull rally of the past few days may have reached its limit," the trader said.

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