Agencies tighten as safe-haven investors seek better yields; pullback possibly ahead

By Kenneth Lim

Boston, June 29 - Agency spreads narrowed on Tuesday as investors sought out yield at the safer end of the risk premium amid a rally in Treasuries.

Bullet spreads tightened about 0.5 to 1 basis point across most of the yield curve, with the 12- to 15-year sector widening slightly because of wider swaps, an agency trader said.

"All in all things went very well, considering the run that we had up in Treasuries," the trader said. "Spreads performed very, very well."

Some investors who would normally put their money into Treasuries appeared to balk at the low rates in that market, and they came to agencies instead, the trader said.

"We do see some of that crossover," the trader said. "I'm not seeing that coming out of the Asian banks or anyone in pan-Asia, but we did see a little bit in Europe and domestically."

Trading activity was robust, taking into account the usual summer slowdown.

"It was fairly active," the trader said, "not light, but not a record."

Callable demand was also strong on Tuesday as investors bought confidently on expectations that low short-term yields will persist for some time.

"People feel pretty comfortable with yields, especially in that five-year and shorter sector," the trader said. "We've been seeing a bull flattener, which means the short-term rates are going down slower than long-term rates. People think that's going to be the case for a while, so what people are playing right now is that seven-years and longer are going to drop down in yield."

Yield seekers

Tuesday's tightening was particularly impressive in light of the strong rally in Treasury prices, because it meant that agency yields had to fall faster than those of Treasuries.

Two factors were working in favor of agencies, the trader said. First, there is a large amount of cash out in the market that investors want to put to work before the end of the month. Second, the U.S. government's strong support of Fannie Mae and Freddie Mac have reduced their risk premiums significantly, to the point where many investors consider short-term paper from those agencies as effectively government-backed debt.

"Mostly everybody who's got cash is buying agencies, since most of the agencies are now considered government-guaranteed," the trader said. "And with the yields as low as they are, agencies look more attractive."

The slow mortgage market has also helped agencies to withstand the Treasury rally.

"What drives that widening most times is trading in swaps," the trader explained. "People become payers in swaps, but since mortgage products and mortgage hedging is so low, we're not seeing servicing of those mortgages being hedged as much."

Pullback possible

The lack of benchmark-sized bullet supply this week could keep spreads tight for the next few days, the trader said. But a pullback was also possible with economic numbers ahead that could catalyze some profit taking.

The U.S. Labor Department on Friday will release non-farm payroll data, which will be keenly watched by investors trying to gauge the strength of the domestic economy.

"We have unemployment coming out," the trader said, noting that agency spreads are about 8 to 10 bps tighter for the month. "We're below 3% now [for 10-year Treasury yields], so if stocks gain you could see some profit taking."

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