Agency spreads push out as Fed cuts buybacks; Freddie Mac's reopened two-years take hit

By Kenneth Lim

Boston, Nov. 4 - Agency spreads widened on Wednesday after the Federal Reserve's Open Market Committee unexpectedly cut the size of its agency debt purchase program.

The move also hit Freddie Mac's newly reopened 1.125% Reference Notes due 2011, which widened after the $1 billion auction closed.

Bullet spreads widened by about 4 to 5 basis points across the yield curve on Wednesday, an agency trader said.

"They widened obviously on a bit of a surprise from the Fed," the trader said.

But even as the Fed's announcement was unexpected, the market's reaction also seemed muted, the trader said.

"Customer flow was pretty much not there," the trader said. "It didn't seem like there was much of a reaction. I thought spreads would widen even more...Agencies stuff was almost like a side show, when it should have been the main event."

The tight supply in agencies could have kept investors from selling, as did expectations that the Fed would be announcing on Thursday its outright coupon purchase action for the week.

"The market was unsure about how far we'd go," the trader said. "What helped was that there would be a buyback that will be announced tomorrow. Guys are expecting them to target the five-years, so lots of guys trading November '14s...We probably could have been 4 to 10 bps wider if not for the buyback."

There may be more to come from investors in terms of a reaction.

"We might see some selling overnight from Asia, but I don't think they own that much," the trader said.

Non-typical agency bullets could also be affected.

"The key for me is, what's going to happen to the greater universe of agencies, like TAPs and MTNs, callables that have become bullets, how are those [issues] going to trade?" the trader said. "I would expect to see some widening there. We're coming to year-end, and if clients don't own a lot, they're looking to lighten up on Aaa paper, and what they have to unload are TAPs, Farmer Macs and so on."

Fed cuts buyback program

The FOMC reduced the size of its agency debt buying program to $175 billion from $200 billion, according to a statement on Wednesday following the conclusion of the committee's November meeting.

"The amount of agency debt purchases, while somewhat less than the previously announced maximum of $200 billion, is consistent with the recent path of purchases and reflects the limited availability of agency debt," the statement said.

The statement clearly caught the agency market unawares.

"That leaves them with only $29 billion left to buy over the next 21 weeks," Guggenheim Capital Markets head of U.S. fixed income rates trading Thomas L. di Galoma wrote in a note. "Odd timing for this statement in that last week they bought over $5 billion and despite their perception that there isn't much left out there, they were shown $12 billion last week."

Margaret Kerins, an analyst at RBS Securities, expects agency spreads to widen further as the buying program is wound down through the first quarter of 2010.

Kerins perceived four possible implications from the announcement. The first, and deemed improbable, is that Congress will resolve the status of the government-sponsored enterprises in the first quarter of 2010. The U.S. Treasury's GSE Funding Credit Facility, which expires on Dec. 31, could be extended and the terms made friendlier for participants.

The move also suggests that the agencies "have very little to issue and do not need the Fed." Finally, the market was probably too rich for the Fed.

"Spreads are so rich that the Fed does not feel the need to support these levels and believes that the equilibrium in its absence will not be too onerous for the GSEs," she added.

Freddie Mac hit in secondary

Freddie Mac's newly reopened 1.125% Reference Notes saw spreads expand by about 5.5 bps on Wednesday after $1 billion was auctioned at a stop spread of about 24.5 bps over Treasuries, the trader said.

"That was a bit of a disaster," the trader said. "They came out 2.5 bps through the offered side. The notes were 26.5 bps, 26.25 bps before the announcement; they came at 24.5 bps and were immediately offered at 26.25. Then they blew out to 27.5 bps, and after the Fed they blew out to 31. Now we're at 30."

The stop yield was 1.179% at a price of 99.886974. The bid-to-cover ratio was 4.01.

The offering raises the outstanding principal amount of the notes to $4.5 billion.

The trader, who did not buy any of the notes, acknowledged that the timing of the deal was unlucky but thought that it was also a bad move by the Street to buy the notes so much tighter than the existing paper was trading.

"To buy at 2.5 bps through is just crazy," the trader said. "You're not making a million dollars being a bookrunner."

Freddie Mac has Reference Notes announcements scheduled for Nov. 16 and Nov. 30, and the agency will probably go further out on the yield curve the next time, the trader said.

"They've done a reopening here today, so what are they going to bring on the 16th and 30th?" the trader said. "Maybe a three- or five-year on the 16th and a pass on the 30th would be my guess."

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