Agencies widen as Treasuries rise on Greece downgrade; market eyes supply, Fannie Mae

By Kenneth Lim

Boston, May 9 - Agency spreads eased wider on Monday under the pressure of falling Treasury yields, with the short end of the yield curve faring better than longer maturities.

Bullet spreads closed the day about 1 to 1.5 basis points wider versus Treasuries, an agency trader said.

"Agencies are not great, but OK," the trader said. "It seemed like a little better selling in the longer end, and better buying in the shorter end...people are scared of rates coming back around again."

The callable market saw decent activity, with callable spreads flat to out by about 1 bp versus Treasuries.

"Spreads have gotten so tight, especially in the front end of the market, that people are willing to take on the call risk," the trader said. "Even in corporates and mortgage-backed securities and agencies, due to the fact that supply is somewhat shrinking, demand is still somewhat strong."

Treasuries continue climb

Agencies could not keep up with the climbing Treasury market as new concerns about Greece's debt crisis sparked a fresh flight to quality.

Standard & Poor's cut Greece's credit rating to B from BB- on concerns that the European Commission may restructure the Greek debt that it holds. Speculation mounted over the weekend and Monday that Greece may have to seek to leave the euro zone.

"We've had a pretty big push down in rates," the trader said. "With the economic data that's kinda coming out and commodity prices going up, I think the majority of people think we could still go down a little in rates, but not substantially."

A fair bit of the drop in Treasury yields has been attributed to short covering by Treasury bears who were caught by surprise by the recent rally in Treasuries. The trader said the market was ready for another drop in yields early Monday.

"We came in this morning and yields were higher, and we just kind of got lower as the day went on," the trader said. "I think we're in a range. Any time 10s go back to the 3.20%, 3.18% level, you can see people buying."

But the low yields are keeping some absolute rate investors away from agencies, the trader said.

"You've got two really big things happening," the trader said. "One, rates are very low, and two, spreads are very tight. If you look over the past five years, we're definitely on the top 20% of the tight side...So where's my risk-reward?"

Supply remains tight

The tight spreads in the agency market are enjoying strong support from diminishing supply. Fannie Mae and Freddie Mac are required to reduce their portfolios, while Federal Home Loan Banks is also seeing its funding requirements shrink simply because banks are not tapping the housing agency as much now.

"Fannie Mae and Freddie Mac, how many times have they not funded over the past few months?" the trader said. "It's a continuation of shrinking mode."

Fannie Mae has an announcement on Benchmark Notes scheduled for Wednesday. The agency skipped its previous announcement just a week ago, on May 3, and the market is not expecting two straight passes in a row.

"My guess, given the cheapest part of the curve right now is in the two- to three-year sector, is they'll come with a two- or three-year," the trader said. "There's a decent amount of demand in those sectors."

Treasury supply will also be on the top of investors' minds in the next few days as the Treasury offers $32 billion of three-year notes on Tuesday, $24 billion of 10-year notes on Wednesday and $16 billion of 30-year bonds on Thursday.

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