Agencies widen on broad sell-off amid better economic data; traders expect more volatility

By Kenneth Lim

Boston, Dec. 10 - Agency spreads widened slightly on Friday amid a broad fixed-income sell-off on stronger economic data.

Spreads eased out by 0.5 to 1 basis point across the yield curve mostly on the back of a brief afternoon sell-off. On the week, spreads ended about 4 to 5 bps wider.

"It's been a pretty quiet day, but all in all the market's done pretty well," an agency trader said. "Spreads have held in there."

Callable issuance was decent, although volumes faded a little from previous sessions.

"Issuance is still going OK, although it did slow down some today after midday," the trader said.

Overall trading activity was muted, especially later in the afternoon. The market has had an extremely volatile week, and investors were glad to take a break, the trader said.

"It's been a really volatile week, and the market just took a breather after 1 p.m.," the trader said.

Agencies survive rough week

Bond markets saw prices fall on Friday on stronger economic data.

The U.S. trade deficit fell in October, improving prospects for the U.S. economy and trimming demand for bonds. The U.S. Treasury Department also reported an increase in the budget deficit, raising inflation fears.

Amid the bond sell-off, agencies fared relatively well when compared to Treasuries as real money investors sought to take advantage of the higher yields.

"The main reason is you've got a lot of cash on the sidelines, and people are beginning to put money to work at the higher yield levels," the trader said.

The agency market is also getting support on the supply side, with Federal Home Loan Banks earlier in the week deciding against using its calendar slot to issue new Global Notes. Callable issuance has also been slower because issuers expect rates to increase.

"As rates go higher, there are less bonds that are going to be called in agencies," the trader said. "What was in the money has now fallen out of the money. They don't have to issue as much now because they don't expect to have to refinance as much."

Funding levels are likewise more expensive for issuers.

"Even though spreads were coming in, funding was also tightening by 2 to 3 bps," the trader said.

More volatility ahead

More volatility is probably in store in the week ahead, the trader said.

"Tens want to continue to test new highs [in yields] here," the trader said. "With the curve steepening as much as it is, the carry trade is coming back in favor."

With a steeper yield curve, investors do not have to move as far out on the curve to pick up the same amount of yield, the trader explained. While growth in carry trades will usually flatten the curve back, some unique circumstances right now could maintain steepening pressure.

"With what's going on with the Fed and [quantitative easing] and the tax deal, people are increasing growth estimates," the trader said. "With increasing growth estimates and all the money going around, people are looking at higher yields in the long end, so that's going to keep the curve steepening."

High volatility, like the market saw over the past week, is tough on callable investors, the trader added.

"You are seeing some very swift and very serious moves in the market," the trader said. "When you're trading callables, especially, it's not the easiest thing in the world to hedge."

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