Agency spreads narrow ahead of Fed buying; new Freddie Mac three-years close tighter

By Kenneth Lim

Boston, July 16 - Agency spreads contracted Thursday ahead of the Federal Reserve's next outright market purchase, market sources said.

"The market is quite a bit tighter, particularly in the five-year sector," an agency trader said. "The three-year sector is also quite a bit tighter."

Across the yield curve, spreads came in by 1 to 3 basis points, the trader said.

The tightening was greater at the back end of the curve, with the Federal Reserve Bank of New York targeting 10- to 30-year paper in its next open-market action.

The Fed said Thursday that it will buy agency paper due 2016, 2017, 2018, 2029, 2030, 2031 and 2032 on Friday.

Freddie Mac's new 1.75% Reference Notes due June 15, 2012 closed tighter at a spread of around 23 bps. The paper priced at a spread of 24 bps and had traded as wide as 27 bps, the trader said.

The agency market is finding support despite robust selling, the trader said.

"To be perfectly honest, we as a firm have seen better selling," the trader said. "We have seen accounts take profit on agencies, but clearly there's someone out there buying them."

Fed support still key

The market is reading continued support for the Fed buyback program, which targets agency, Treasury and agency mortgage-backed securities, in the latest minutes of the June Federal Open Market Committee meeting, the trader said.

"They had talked about changing the mix, that's what people are most worried about, but they decided against it, so it's sort of status quo right now," the trader said. "My own expectation is that agency buying will probably slow down, but probably not for a few more months."

The Fed's purchases are clearly working in terms of encouraging investors to continue trading agencies, but the program is also probably affecting valuations, the trader said.

"I think there's a little doubt that agencies are not necessarily trading at fair value," the trader said. "They're trading where they are because the Fed is buying them."

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