Agency spreads contract at front end; Fed to target short-term paper in early operation

By Kenneth Lim

Boston, Nov. 20 - Agency spreads continued to inch tighter at the front end of the yield curve on Friday as the Federal Reserve Bank of New York said it will buy two- to four-year paper when the new week begins.

Two-year bullet spreads came in by about 1 basis point, said Broadpoint agency trader Craig Ziegler.

"Everything else is unchanged," he said.

Trading volume thinned out ahead of the weekend and the coming week, which will be shortened by Thanksgiving.

"Except for the buyback announcement for Monday, there really wasn't anything going on today," Ziegler said. "It's really, really quiet today."

Another agency trader noted some buying in the seven-year sector as investors slowly moved further out on the curve.

"Longer paper's been lagging just because Treasuries have been rallying, but I did see some buying in seven-years," the trader said. "Guys [were] moving out of five-years. But where the real buying is, most of the buying's been concentrated on the short end."

Steeper curve

Over the week, the story was of curve steepening in agencies, with front-end paper outperforming longer-dated securities.

"Two-years are in about 3 bps on the week, three-years are in about 3 bps, five-years in 2 bps," the trader said. "The rest of the stuff is wider. Sevens out about 1 bps, 10s about 2 bps."

Corporate notes that were issued under the Temporary Liquidity Guarantee Program - they generally trade through agency desks because of their federal backing - gave up gains from the week before. The Federal Deposit Insurance Corp., which guarantees such paper, on Nov. 6 highlighted that the risk weighting for TLGP debt was reduced to zero from 20%.

"We've seen good selling of TLGP paper to buy agencies, which was an interesting move," the trader said. "That stuff had gapped in on the news about the 0% risk weighting...but after that I think guys were just taking profit in that area, and it just got hammered. They've widened about 6 to 12 bps on the week."

TLGP debt is now trading about 10 bps over agencies, the trader said.

"At 5 bps over, I'd rather own agencies because of more liquidity," the trader said. "But at 10 bps over I'd rather own TLGP."

Fed makes early move

As speculated by several market observers, the Fed announced an earlier-than-usual agency purchase operation for the coming week.

The Fed will target agency notes due 2011 to 2013 on Monday, according to the central bank.

Some investors had been expecting an announcement on Thursday, and "spreads were not happy that there was no announcement" then, Broadpoint's Ziegler said.

But it turned out that the market was not far off the mark, the other trader said.

"They needed to front-load that week because of the holidays," the trader said.

Quiet week ahead

The week ahead will likely be quiet with the Thanksgiving disruption, Ziegler said.

But the other trader thinks spreads could narrow even more.

"I would say spreads will just grind a little bit lower," the trader said, "just because we have no supply at all next week."

The back end of the curve could also play some catch up.

"We had a lot of steepening this week," the trader said. "Maybe the long end will outperform next week."

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