Agencies inch narrower as curve steepens on expectations of Fed action; supply test ahead

By Kenneth Lim

Boston, Oct. 15 - Agency spreads tightened slightly on Friday as longer-dated Treasuries fell on higher expectations that the Federal Reserve would begin asset purchases.

Bullet spreads narrowed by about 0.5 to 1 basis point versus Treasuries.

"It was relatively quiet from the standpoint that spreads didn't move that much," an agency trader said. "Spreads are generally slightly tighter on the day."

Callable issuance remained brisk on the recent run-up in rates and the large volume of paper getting called. Issuers have been calling debt as soon as they can because yields are at historically low levels.

"The call redemption story continues to be very strong," the trader said. "There's a lot getting done in the callable space."

Trading volumes actually picked up slightly on Friday following Fed chairman Ben Bernanke's speech, in which he said there was a case for further quantitative easing.

"We actually saw quite a bit of flow," the trader said. "[We] continue to see better buying. Agencies got to really cheap levels about two weeks ago, and now they're still bouncing back."

Curve steepens

The yield curve steepened on Friday as investors sold off longer-dated Treasuries in the wake of Bernanke's speech.

Bernanke said there was a case for the Fed to buy more government debt in order to raise inflation, although the Fed chairman also stressed that the central bank was taking a cautious stance.

The prospect of the Fed buying front-end paper led to a rally in short-maturity prices, but the risk of higher inflation caused longer-dated bonds to tank.

"Given where we ended up on the day - the market is on the lows right now and with the curve steepening a lot - I think the market was underwhelmed by what he had to say," the trader said.

Swaps fared better at the longer end than agencies, tightening significantly against Treasuries.

"We're barely keeping up with swaps," the trader said. "Long-end swaps were in quite a bit. We underperformed just a bit in the intermediate part of the curve."

Supply test ahead

The agency market had a relatively quiet week and mostly kept in line with Treasuries but could face a bigger test after the weekend when Freddie Mac has a calendar announcement on Reference Notes issuance.

Investors were disappointed earlier this week when Federal Home Loan Banks chose to bring a small $1 billion reopening of an existing two-year series. Segments of the market had been expecting a benchmark-sized offering of new notes.

Freddie Mac has traditionally been a bigger issuer of benchmark bullets than FHLB.

"The real test I think will be next week when we have a little bit of supply," the trader said. "We have Freddie Mac. They're going to announce something...on Tuesday. We'll see what they're having in terms of issuance."

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