Agencies flat as possible government shutdown, potential higher rates add to uncertainties

By Kenneth Lim

Boston, April 7 - Agency spreads closed flat on Thursday as investors remained reluctant to enter the market amid uncertainties about a possible government shutdown and the possibility of higher interest rates.

Bullets closed the day mostly unchanged versus Treasuries, said Mesirow Financial's senior managing director of institutional sales and trading, Joseph J. Riley. The new Freddie Mac 2.5% Reference Notes due 2016 stayed flat, going out at spreads of about 25 bps bid, 23 bps offered.

Trading volumes were light with many investors staying on the sidelines. Even callable issuance was down.

"It's been very, very quiet the last three or four sessions," Riley said. There was "not a lot of issuance in callable stuff."

Uncertainties weigh on market

Despite the flat end to Thursday's trading session, spreads were up and down for most of the day.

"We traded up early, then started to come off; then the Japan earthquake hit and we were up again," Riley said, referring to a 7.4-magnitude aftershock in Japan.

The markets are also unsure about whether Congress can avert a government shutdown because of a stalemate over the budget.

"Everyone's being held hostage by the budget negotiations," Riley said.

Riley said there was a possibility that the Federal Reserve could do some reverse repos if there is a shutdown, reminiscent of what happened during the last federal shutdown in the late 1990s.

"The last time the government shut down they did reverse repos," he said.

Despite all the intraday volatility, agency spreads have been unable to make much of a sustained move in any direction. Riley blamed expectations of higher rates for the lack of enthusiasm in the market.

"It's just been brutal, and we can't find anyone to do anything on top of it," he said. "The belief is we're going to higher interest rates, and people are treading water trying to keep their powder dry."

Market sees higher rates

An agency analyst said the market consensus is that the Fed will raise interest rates before the year is up, and that is taking some of the shine out of existing debt securities.

"Obviously if you think rates are going to go up, you're going to be reluctant to buy notes right now because their value could fall in a few months," the analyst said.

Investors are still unsure about the exact timing of the expected move, and that is adding to volatility in the markets, the analyst said.

For agency investors, higher rates will also be negative for yields, but a little bit of cheapening in the market could be healthy, the analyst added.

"If yields go up a little bit and there's no expectation for a steep increase, higher yields could attract some of the investors who are looking elsewhere right now or just sitting on their cash because the markets are too expensive," the analyst said.

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