Agency spreads tighten on extension trades; market's strength could last into Thanksgiving

By Kenneth Lim

Boston, Nov. 19 - Agency spreads contracted slightly at the front end of the yield curve, outperforming swaps as investors sought value in the three-year sector.

Bullet spreads ended the day about 0.5 to 1 basis point tighter across the yield curve, with stronger contraction coming in three-years, said Michael Skinner, an agency trader at Wall Street Access.

"Spreads at the front end did better today," he said. "But they may have given back a bit along with swaps. We widened out a little here at the end of the day, but considering how much Treasuries have rallied in the last couple of days, it's good how well spreads have held."

The curve steepened, and agencies held better than swaps, which had actually outperformed agencies the past couple of weeks. Rate investors were also willing to sell with yields getting dragged down by a strong Treasury market.

"You've got guys selling absolute yield levels on Treasuries, and guys buying since they're cheaper compared to swaps," Skinner said. "It's good two-way flow, let's put it that way."

Market volumes are also picking up because of the coming Thanksgiving holiday.

"Guys are trying to take advantage of liquidity now given that there might not be any later," Skinner said.

The pickup was welcome after a lackluster start to the month, when agencies came under selling pressure.

"You've had people selling, guys maybe getting a little off early on year-end trades....I think that may have caused a bit of the widening in the front end," Skinner said. "But I think now for the most part agencies have gotten cheaper."

Extension trades

Mark Noble, head of agency at MF Global, said yields of front-end paper, discount notes and bills "just basically collapsed" on Thursday.

"Bills and discount notes were insatiable," he said.

The hunger for shorter-end paper helped to explain the strength in the three-year sector as investors moved further out on the curve, Noble explained.

"They basically moved out the curve to pick up yield," he said. "People will sell '11 paper to buy late '11 paper and three-year paper. Five and 10-years have just been kind of steady, strong."

Noble said the market usually sees rate-based selling when Treasury yields fall as much as they have, but this time investors do not have significantly better cash alternatives.

"Usually there's another alternative, but where the bills market is and where front-end rates are, nobody's selling," he said.

So the market is seeing "nothing but extension trades," Noble said.

Staying strong

Skinner expects that agencies will continue to show strength heading into the holidays.

"There's no supply until the 30th [by Freddie Mac]," Skinner said. "We should hold well the next couple of sessions."

Noble agreed, pointing out that the conditions behind the recent rally will likely remain for a while.

"I don't see any renewed reason to see selling," Noble said.

The Federal Reserve could also provide support with a purchase operation in the next few days. The market had been speculating about an earlier-than-expected action by the Fed, which already bought $1.531 billion of agency notes at the long end on Tuesday, because the holiday-shortened week ahead could make it difficult for the central bank to carry out a meaningful operation.

"They could announce tomorrow for Monday purchase or announce Monday for Tuesday purchase," Noble said. "I would expect to see an announcement for early next week or not at all."

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