Agencies lose ground versus Treasuries on concern about Europe; FHLB offering anticipated

By Kenneth Lim

Boston, Sept. 6 - Agency spreads widened slightly on Tuesday as heightened fears about Europe's ability to overcome its debt crisis fueled bets that the Federal Reserve would intervene with long-end purchases.

Bullet spreads closed the day half to 1 basis point wider versus Treasuries, while also slipping against swaps.

"We're definitely having a down day," said Mary Ann Hurley, vice president of fixed income trading at D.A. Davidson & Co.

Trading volumes were quiet in general, but callables saw much better action than bullets because of the market's hunger for yields.

"People are reaching for yields, so with rates just so low, we're seeing more activity in the callable market than in the non-callable market," Hurley said.

Yields hit record lows

The 10-year Treasury yield reached an all-time low on Tuesday as investors returned from the Labor Day holiday to reports that governments in Greece and Italy may not be able to push through austerity measures that are conditions for receiving critical bailout funds.

Germany is also facing strong domestic pressure against continuing to bankroll those bailouts, raising questions about the euro zone's ability to adequately address its debt problems.

"These are not ordinary times," Hurley said.

The Europe news, coupled with ongoing concerns about the U.S. economy, pushed investors toward the safety of Treasuries, especially in the longer end of the yield curve. The 10-year Treasury yield dipped below 1.97% during the day - a record low - before settling at 1.98% at the end of the day.

Investors are also betting that the Fed will announce new stimulus measures to flatten the yield curve when its next policy meeting concludes on Sept. 21. The Fed is expected to pursue a policy of actively adjusting its portfolio to hold more longer-dated debt.

"That's probably really the most that they can do given the opposition by many of the members to [a third quantitative easing]," Hurley said.

Hurley expects yields to be volatile in the days ahead, but to drift even lower in the longer end of the yield curve.

"On the 10-year [Treasury] note we have stayed below that 2% level all day," she said. "We're definitely well off the highs in price, but still just the fact that it continues to trade below 2% is a sign that rates seem to be definitely on the downward tick."

FHLB announcement ahead

The market expected Federal Home Loan Banks to announce an offering of Global Notes on Wednesday as part of a calendar opening.

The government-sponsored enterprises have mostly been issuing in the five-year sector and shorter since 2009, but the yield curve is so flat and issuing longer maturities is so cheap that speculation about FHLB's announcement has also drifted out on the curve.

"I've heard as far out as five to seven years," Hurley said. "I'm really hearing a mixed basis just because of the fact that we're anticipating the Fed to sell the shorter end and buy the longer end, which may impact their decision making."

The last benchmark bullet supply in the agency market was on Aug. 17, when Fannie Mae sold $4 billion of 1.25% notes due 2016.

The market on Monday was not seen setting up for supply.

"It's a very difficult market to short, especially shorting something when you don't know the exact sector it's going to be in," Hurley said.

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