Agencies end quarter tighter versus Treasuries, but market sees weakness in Q2

By Kenneth Lim

Boston, March 31 - The agency market continued to richen versus Treasuries over the first quarter of 2010, but it will begin the next three months amid signs of weakness.

"It's been a pretty good quarter," said Guy LeBas, chief fixed income strategist at Janney Montgomery Scott. "We saw spreads perform pretty well...year-to-date total return is about 1%."

Bullet spreads in the five-year sector began the year at around 16 bps over Treasuries but are now down to about 8 or 9 bps, LeBas said.

Part of the tightening has been led by swaps, which have narrowed significantly over the past quarter, LeBas explained. The swap tightening was mostly due to high volumes of corporate bond issuance and the hedging related to that issuance.

"One of the things you have to look at is the swaps market," he said. "Swap spreads inverted versus Treasuries in the seven- to 30-year part of the curve...and agencies typically have a greater correlation to swaps than Treasuries, so they were affected by this inversion as well."

Callable strength

Callable issuance, especially step-up structures, remained a main source of market activity in the first three months, LeBas said.

"One of the trends we've seen is a much greater issuance of structures, like step-ups, and there's definitely been demand for that," he said.

But LeBas thought that the step-up allure could be strained as demand reaches a plateau.

"I think the market's getting a little disillusioned with those structures pretty soon," he said. "Step ups and other heavily structured products attract a certain kind of buyer, the yield buyers, and that's reaching saturation point. Once we get the total return buyers back into the market, demand for the non-step-up callables should come back.

"So we actually like [straight] callables," LeBas added.

Rich valuations

The tightening across the board for agencies - across sectors of the yield curve and in both bullets and callables - has led to views that the agency market is too rich at the moment.

"I think we are rich by nearly any term you can phrase it by," LeBas said. "Now it's really hard to justify putting any money into agencies."

LeBas said some widening could be on the horizon in the coming quarter with the Federal Reserve no longer buying agency paper on the market.

"Going forward it's going to be driven more by organic factors," he said. "We're looking forward to less issuance by Fannie Mae and Freddie Mac...but as rates creep higher we will probably see widening trends."

Fed ends purchases

One agency analyst also expected widening because of investor caution surrounding the end of the Fed's purchasing program, which ended Wednesday. But investors still appear to be very eager to pick up agency notes on dips, the analyst said.

"I expect to see more widening, nothing major, just the fact that people want to wait and see what happens," the analyst said. "But there's so much demand at cheaper levels that it's going to be hard to get that much wider."

The supply picture is also looking positive for spreads, with funding needs still shrinking at the agencies, the analyst said.

"The supply story is very favorable," the analyst said. "There's not very much portfolio growth there."

Christopher White, who leads the fixed income sales and trading business at Moors & Cabot Capital Markets, said the outlook for the next quarter could depend on what the Fed does next. The Fed has almost $170 billion of agency notes on its portfolio right now, and disposing of them could put pressures on the market.

"My thought is it all depends on what the Fed does next," he said. "I don't expect the Fed to tighten its policies in any way, but everyone's looking at how they're unwinding...that's the next step."

Negative news on the regulatory front could also affect spreads.

"It just takes one bad news print," White said.

GSE future to be decided

The past quarter saw the debate begin in Washington over the future of the government sponsored enterprises, with Treasury secretary Timothy Geithner telling Congress that the administration will seek public comment on options on April 15.

LeBas did not think that agency investors have much to fear in the next five years or so, although occasional comments by lawmakers in the process could trigger short-term movements.

"Every bank in the country, and every bank in the world owns [Fannie Mae and Freddie Mac]," LeBas said. "Were they to default, we would have a massive wave of failure among U.S. banks. There's no practical way to end it quickly."

The other agency analyst added that the next presidential elections in 2012 could also limit the amount of change expected in the next couple of years.

"In 2011 everyone's going to be worried about who's running for president, and it's not going to be the time to be talking about Fannie Mae and Freddie Mac," the analyst said.

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