Agencies tighten modestly as manufacturing data beat forecasts; more volatility expected

By Kenneth Lim

Boston, July 1 - Agencies narrowed slightly on Friday as Treasury yields continued to climb on positive economic data.

Bullet spreads tightened by 1 basis point to 2 bps versus Treasuries across the yield curve, although trading activity was extremely light.

"Today was extremely quiet," one trader said. "Spreads came in a little bit, but that's based on very, very little volume."

The lack of liquidity made it hard to get an accurate picture of the market ahead of the long weekend.

"There isn't enough volume to definitively say how much spreads came in by," the trader said. "The general tone of the market, the tightening is what's happening, but it's hard to pinpoint how much spreads would have moved if we had Wednesday's volumes, for example."

The callable market was also quiet.

"It's the holiday," the trader said, referring to the closing of markets on Monday for the Fourth of July.

Yields climb further

Absolute yield levels continued to rise Friday after the Institute for Supply Management reported a stronger-than-expected manufacturing report for June.

The ISM Manufacturing Index rose to 55.3 in June from 53.5 in May, beating Street forecasts for a reading of 52.

"The ISM manufacturing data came in better than expected, which led to a sell-off in Treasuries," the trader said. "We had the Chicago PMI yesterday that was also better than expected, so I think the market is rapidly backing away from the flight to quality trades that were made over the past two weeks."

The selling of Treasuries was supportive of narrower agency spreads, especially in longer maturities.

"Long end agencies are much more resilient than the corresponding maturities in Treasuries simply because there's a lack of supply beyond five years," the trader said. "When there's selling in bonds, agency bullets that are that far out are going to outperform Treasuries."

More volatility ahead

The past week's dramatic climb in yields was part of a month of extremely high volatility in Treasury and spread markets.

The markets' wild swings were driven by uncertainty about the debt crisis in Greece and about the state of the U.S. economy. Those questions have not been resolved, so investors could be looking at more volatility in the coming weeks.

"I've learned to be very careful about making predictions," the trader said. "One week ago I didn't think we were going to see 3.20% again before the third quarter, and today 10s were right around there. I think the only certainty is more uncertainty."

The agency market could remain at tight levels versus Treasuries with no agency supply expected after the long weekend. Freddie Mac has a calendar announcement on July 6, but the agency just sold $5 billion of three-year notes on Thursday.

"I don't think they have the needs now especially after yesterday's three-years," the trader said.

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