Agencies tighten, yields drop on hopes of debt ceiling deal; U.S. downgrade still possible

By Kenneth Lim

Boston, Aug. 1 - Agency spreads narrowed slightly on a quiet Monday amid cautious optimism about a deal to cut the U.S. budget deficit and raise its debt ceiling.

Bullet spreads closed the day about half to 1 basis point tighter versus Treasuries across the yield curve, although trading volumes were extremely light.

"We opened up tighter today," said Mike Goldman, head of agency trading at Guggenheim Partners, noting "almost no trading, almost no new deals. A handful of secondary trades were quoted tighter."

The callable market was quiet as well, with Monday's rally in Treasuries hitting some holders.

"With the rally in Treasuries, a lot of callable guys got caught underwater, to the extent that they've hedged themselves somewhat, but it's pushing a lot of them to the sidelines," Goldman said.

Yields decline on fears

Yield levels closed the day sharply lower on Monday on the back of a highly disappointing manufacturing activity index report by the Institute for Supply Management.

The index fell to 50.9 in July from 55.3 in June. A reading below 50 suggests contraction in the manufacturing sector. Street estimates were for a reading of about 54.3.

The flight to safety also got a bit of a boost from news over the weekend that congressional leaders in Washington and the White House had agreed on a deal to raise the debt ceiling and to cut the deficit. Congress was expected to vote on the proposal late Monday, in time to avert the Aug. 2 deadline for potential default.

"Clearly there's a better tone in the market in anticipation of the debt deal," Goldman said. "It's the risk-on trade again. Given how badly stocks opened up, it's a good sign that agencies managed to hang in there."

Uncertainties persist

If the debt ceiling proposal is approved, agency spreads should narrow, Goldman said.

"Last week we were 5 to 7 bps tighter than where we are right now, so there's no reason why we can't get back there," he said.

But Goldman said the market was still worried that the deal would get approved, and that ratings agencies would still downgrade U.S. debt even if the deal received enough votes.

"It's not done yet," Goldman said. "There's still a question of whether there will be a downgrade."

An agency analyst thought that the downgrade risk was high, although that would be a "much slower moving and hopefully less scary outcome" than a default by the United States.

"[Standard & Poor's] was quite clear in its requirements," the analyst said. "I don't believe any of this talk about a lot of pressure not to downgrade...I read that the government will be happy with split ratings, meaning S&P has a Aa or Aa+, and [Moody's Investors Service] has a Aaa with negative outlook. That's fine for them."

The analyst thought that spreads should come in as long as a deal is in place.

"I don't expect to see twos at 8 bps over, but something along the lines of 10, 11, 12 bps area," the analyst said.

Still investors might want to wait until the ratings agencies weigh in on the deal and the dust finally settles before coming back to buy, the analyst said.

"I think the whole thing is limited by the downgrade," the analyst said.

Freddie Mac ahead

Freddie Mac may not offer new Reference Notes this week, Goldman said.

The agency has an issuance announcement on the calendar on Tuesday, but funding levels are not optimal at the moment and Freddie Mac does not have large funding requirements, he reckoned.

"Valuations are still not great," Goldman said. "But if they do anything I think it will be in the front end."

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