Yields slip amid strong Treasury auction, Europe fears; steep curve draws extension trades

By Kenneth Lim

Boston, May 24 - Agency spreads closed flat on a quiet Tuesday as yields slipped modestly on persistent concerns about the debt crisis in Europe.

Bullet spreads found relief from profit takers, ending the day unchanged versus Treasuries a day after a broad sell-off in agencies.

"Very little change in spreads," said D.A. Davidson vice president of fixed-income trading Mary Ann Hurley.

Secondary trading was quiet. There is no benchmark supply scheduled for the week and a long weekend beckoning.

"It was very, very quiet," Hurley said. "One message I got said the agency market is ready for summer."

Callables were a little more active, with step-up structures drawing a good amount of interest.

"We're seeing a fair amount of interest in those at this point," Hurley said. "People seem to like the type of paper that has longer call protections, the longer step-ups with bigger jump-ups in the back. Chances are it's going to get called unless we're headed into a large disaster."

Europe, auctions lower yields

Yields slipped modestly on Tuesday in line with Treasuries as safe-haven bids kept yields at recent lows.

The Treasury sold $35 billion of two-year notes in an auction that "went well," Hurley said. Bids were 3.46 times the amount of notes being offered, and there was strong non-dealer demand.

The market was also mindful of the ongoing credit concerns in Europe, where Greece and Italy have seen credit ratings downgrades over the past few sessions.

"Europe is going to continue to be in play, and I don't expect any near-term resolution of that," Hurley said.

The agency market essentially followed the lead of Treasuries, but it could not gather enough momentum amid the lack of liquidity to move spreads either way.

"What's happening in Treasuries is translating into agencies as well," Hurley said.

Yield curve stays steep

The yield curve is now extremely steep, and investors are increasingly looking to pick up better returns by extending maturities, Hurley said.

Two- to five-year spreads in the Treasury market are now about 127 basis points, "which is a lot," Hurley explained.

"I can't tell you where the spread runs historically, but it's definitely got to be on the wide end," she said.

Investors who move out on the curve can improve their yields with a relatively small increase in risk, Hurley said.

"We are seeing that investors can pick up better yields without having to pick up too much duration risk by extending out into the five-year area compared to the two- or three-year area, unless you're bearish on the Fed tightening aggressively," she said.

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