Agency spreads tighten on Treasury support; compression overdone at long end, trader says

By Kenneth Lim

Boston, Dec. 31 - Agency spreads remained tight on Thursday as the market continued to ride on the support of the U.S. Treasury.

Bullet spreads in the 10-year sector were tellingly tight at about 14 basis points over Treasuries, said Michael Skinner, an agency trader at Wall Street Access.

The narrowing was a combination of year-end extension trades as well as a reaction to the Treasury's decision to remove limits on the amount of aid that Fannie Mae and Freddie Mac can receive from the Treasury for the next three years, he said. A dearth of Aaa rated paper also helped agencies gain ground over the week.

"Spreads have had an impressive performance in the last week of the year," he said.

Trading volumes were thin ahead of a long weekend and bond markets operating for only half the day.

"It's been quiet, but I still have a sense that there's still some demand," Skinner said. "Maybe it's because I'm the only one still around."

Callable issuance was also light, although investors remained partial toward step-up structures.

"We still see continued demand, more so in the step-up arena," Skinner said. "People are looking at those with rates expected to rise in the coming year. You need protection against this potential rate hike."

Treasury surprise boosts market

The final week of the year saw investors pull agency spreads significantly inwards after the Treasury announced a number of moves on Christmas Eve aimed at reaffirming its support for Fannie Mae and Freddie Mac.

"It was a very sneaky announcement," Skinner said.

The Treasury on Dec. 24 said it would provide preferred-stock funding to Fannie Mae and Freddie Mac for the next three years for as much as they need to remain in positive net worth. The previous limit was $200 billion per agency.

The Treasury also eased requirements for both agencies to reduce their retain portfolios.

"Ten-year spreads came in about 10 bps straight after that happened," Skinner said. "There are some shorts out there, but the big guys are just mopping them up."

The market, which had hoped for the Treasury to increase its lifeline for Fannie Mae and Freddie Mac, was nevertheless surprised by the extent of the expansion of support.

"I think it came as a surprise for everybody," Skinner said. "Why do it on Christmas Eve with nobody around? I guess with the [Federal Reserve's] purchase program ending, it's a way to keep spreads somewhat well bid. But they did it somewhat sneakily."

Slight correction possible

Agency paper at the front end of the curve now trades extremely close to Treasuries, and Skinner does not expect that to change much in 2010.

"I guess the front end in a lot of ways should be the same as Treasuries," he said. "Whatever happens to Fannie Mae and Freddie Mac, it's not going to happen in the next six to 12 months."

But the tightening in five-years and beyond could be a little overenthusiastic, he added.

"We don't know what the future is for Fannie Mae and Freddie Mac," Skinner said. "I think it's probably a little overdone, to be honest with you. Next year I would be surprised if we take a breather and come out a little wider."

The fact that the Fed's agency coupon purchase program, which ends after the first quarter of 2010, will soon leave a hole on the demand side will also put widening pressure on spreads, Skinner said.

"Going into next year we're probably too tight," he said. "I know this announcement was a help, but when you lose that giant buyer in the market, something's got to give."

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