Agency spreads narrow as Fed wraps up purchase program; Freddie Mac could offer two-years

By Kenneth Lim

Boston, March 24 - Agency spreads tightened slightly on Wednesday as the Federal Reserve Bank of New York completed its coupon purchase program.

Looking ahead, Freddie Mac could announce a benchmark-sized two-year offering of Reference Notes on Thursday, market sources said.

Bullet spreads ended about 1 basis point narrower on Wednesday, with the shorter maturities tightening by about 0.5 bp more, said Joseph J. Riley, senior managing director of institutional sales and trading at Mesirow Financial.

"We saw most of the interest in the three- to five-year sector, very little in the long end," he said.

Part of the narrowing was related to poor Treasury auctions, which led to a "pretty good meltdown" in Treasuries, Riley explained.

"Treasury auctions haven't gone too well," he said. "Today's five-years was a disaster...as the [rates] market backed up, the spreads did back up slightly."

Callable issuance remained "the active part of the market," Riley said.

"As long as interest rates remain where they are, existing paper's going to be called and new paper's going to be issued to replace it," he said. "Step-up bonds continue to be very attractive to a lot of buyers...a lot of people protect themselves against the event of a rise in interest rates, whenever that is."

Fed completes purchases

The Fed bought $1.5 billion of agency notes due March 2012 to January 2014 on Wednesday in the final operation of its coupon purchase program.

The central bank has bought about $169 billion of agency notes through the program since December 2008.

"It went as well as anticipated," Riley said. "I think so many people talked about this that the market was ready for it. I don't see it changing the dynamics of the market too much."

But the program could still have lingering effects on the market, especially when the Fed looks into reducing the amount of agency debt that it holds, Riley said. The Fed has said it plans to allow some of the debt to run off as they mature, but such a strategy may not be feasible for longer-dated notes.

"I think the important thing will be when they sell off the assets," Riley said. "Obviously they won't do that until they feel the market is ready...They could allow some of the shorter maturities to mature, but I can't see them carrying on like that forever."

Another agency trader said the ending of the Fed purchase also cast a shadow over longer-dated paper because it removes a significant piece of support for the long end of the yield curve.

"The concern now is nobody's going to step in any more to buy five years and out every few weeks," the trader said. "For the last year or so you could count on the Fed coming in to buy in the long end, so any kind of concern in the long end could be contained. In the front end you have the Treasury supporting that part of the curve, but out beyond three years you've got nothing."

Freddie Mac up next

Freddie Mac could announce an offering of two-year Reference Notes on Thursday as part of a calendar issuance, the trader said.

"I've heard two- or three-years," the trader said. "I don't think they'll do another three-year after the $5.5 billion earlier this month, and two-years seem to be the cheapest for them."

The trader said Freddie Mac may not be able to get another $5.5 billion deal this time because demand has waned slightly after the last few benchmark offerings were considered large.

"We saw quite a bit of supply, and the last one, the [Federal Home Loan Banks] two-years, didn't do so well," the trader said.

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