Agencies widen, underperform swaps and Treasuries as lack of debt ceiling deal raises fear

By Kenneth Lim

Boston, July 18 - Agency spreads widened sharply on Monday as concerns about the U.S. debt ceiling led to a sharp sell-off in U.S.-dollar spread assets.

Bullet spreads underperformed Treasuries and swaps on the day as a deal to raise the U.S. debt ceiling continued to elude lawmakers. Front-end spreads widened by about 1 to 2 basis points versus Treasuries, while longer maturities lagged even more.

"We've just seen very good selling all across the board today," a trader said. "People are very nervous about what's going to happen to agencies in light of a potential downgrade."

The callable market also quieted amid the market's nervousness about holding U.S.-backed debt.

"Over the past few months, callables have been very active - great demand, great appetite," the trader said. "But this is the first time in a while that we're seeing a cautious slowdown in callables as people assess the situation a little bit."

Discomfort with debt ceiling

Investors dumped agencies after markets reopened with no deal on the debt ceiling over the weekend.

The Treasury Department has told lawmakers that they have to raise the U.S. debt ceiling by Aug. 2 in order to avoid a default on government obligations. The credit ratings agencies have warned that they could cut the U.S. credit rating if the U.S. defaults on its debt.

On July 15, Standard & Poor's said that Fannie Mae and Freddie Mac would lose their Aaa ratings as well if the U.S. rating is cut, because of their direct reliance on the government.

The continued absence of a deal to raise the amount that the country can borrow led Treasuries and agencies to lose ground against swaps.

"Even with swaps tighter on the day, there was a lot of selling in agencies, and that's cheapened them up a bit," the trader said.

The selling in agencies was widespread, the trader added.

"Jeez, it's just a combination of domestic, overseas, long end, short end," the trader said. "Everyone was selling."

The trader acknowledged that most people in the market still expect U.S. lawmakers to reach a deal in time to avert default. But as the deadline looms closer, the level of confidence has been shaken.

"If you and I were talking about this a month ago, we'd think there was a 1% chance that they wouldn't reach a deal," the trader said. "But now it's a 20% to 30% chance. It's definitely not 50% and definitely not 100%, but it's become enough of a probability that you have to plan for that scenario. Accounts are planning for it, so they're doing some dumping."

Rebound possible

Monday's dramatic sell-off in agencies suggests that spreads could snap back in if a debt ceiling deal emerges, the trader said.

"I think what's going to happen is Treasuries is going to rally massively, swap spreads will probably widen, and agencies will initially tighten as well then along with swaps," the trader said. "But that's just a convoluted way of saying I think agencies will tighten back if there's a deal."

The debt ceiling will probably dominate market sentiment in the week ahead.

Investors will also be looking for possible supply from Federal Home Loan Banks, which has an announcement Tuesday.

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