Agencies narrow at front end amid Korean tensions; market liquidity expected to decline

By Kenneth Lim

Boston, Nov. 23 - Agency spreads tightened at the front end of the yield curve on Tuesday but closed flat elsewhere in another quiet session for the market.

Two-year bullet spreads closed about 1 basis point narrower versus Treasuries, while the rest of the yield curve finished the day unchanged, an agency trader said.

"With the rally in Treasuries earlier in the day, we saw some light buying in the agencies in the one- to three-year area," the trader said. "Two-years held on to their gains, but the rest gave them back."

Trading volumes were thin with the Thursday Thanksgiving holiday just around the corner.

"Bullets were very, very quiet," the trader said. "There's not a whole lot going on."

Treasury prices rose on Tuesday as investors sought out safe-haven assets after North and South Korea exchanged artillery shots. That uncertainty added to wary investors' concerns about Ireland's credit crisis.

"That led to the sort of bids that we saw in the Treasury market," the trader said. "Corporates definitely opened today 5 to 10 bps wider, although the knock-on effect was more in corporates than our agencies."

Agencies weathered the geopolitical fears better because of the U.S. Treasury's stated commitment to keep Fannie Mae and Freddie Mac liquid for the next couple of years.

"Agencies are essentially Treasuries, so they're just not going to widen on something like that," the trader said.

Callable resurgence

The week has been good for secondary callable trading, and on Tuesday investors continued to seek out callable paper at a brisk pace.

"Callables were active this morning," the trader said. "The rally in Treasuries has brought buyers back. Stuff done two to three weeks ago are now at significant discounts, and that's why callables have been able to move."

Primary issuance also slowed down the past couple of weeks, which has also helped to reduce supply pressure on the callable market.

"Finally agency paper looks a lot better versus Libor, which is helping to bring some buyers in," the trader said. "Callables at Libor minus 8 to 9 bps have cheapened to Libor minus 3 to 4 bps."

Year-end rush

The amount of market activity on Wednesday will depend on how swaps move, the trader said.

One unusual observation was that while most investors have not begun to prepare for the approaching month end, some are already setting up for the end of the year.

"We're seeing more year-end kind of stuff from clients," the trader said. "A lot of end-users are already starting to position for year-end. It seems like year-end begins earlier and earlier every year."

If investors are already doing their year-end business now, volumes could fall quickly from now until Dec. 31 as those investors wrap up their year. Indeed, spreads between off-the-run and on-the-run paper have started to widen, the trader said.

"If you have something you need to do from now until the year-end, you'd better do it in the next couple of weeks," the trader said.

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