Agencies widen against Treasuries, swaps as confidence plunges on outlook for downgrade

By Kenneth Lim

Boston, July 26 - Agency spreads underperformed Tuesday as investors sold on rising fears that U.S. lawmakers would not be able to avert a downgrade of government debt.

Bullet spreads widened by about 2 to 4 basis points against Treasuries across the yield curve and expanded by about 1 to 2 bps versus swaps. Trading volumes were thin, adding to volatility.

"Agencies got smacked pretty good today," an agency trader said. "I don't think there's much depth in the Street."

The callable market, which had been active over the past few weeks, was also lackluster amid uncertainty about how the deadlocked debt ceiling negotiations will eventually play out.

Federal Farm Credit Banks, which typically sends out indicative offerings to dealers before committing to them, pulled two prospective auctions Tuesday because they could not get the bids that they wanted, the trader added.

"Whether it's vacations or the approach of August, the spigot suddenly turned off," the trader said. "Flows have been much more subdued."

Downgrade worries hit spreads

The market endured another session without progress on negotiations to cut the country's budget deficit and to raise the debt ceiling.

"I think it's just come to the point where people have to, whether they like it or not, price in the reality of a ratings downgrade," the trader said.

Treasury yields were actually lower on the day, so agencies' underperformance was slightly puzzling.

"It's such a goofy situation, because if the government gets downgraded, national agencies will get downgraded as well because they're essentially all the same entity, so they should move in tandem," the trader said. "I think, net-net it will be widening versus swaps and widening versus Treasuries, but less so versus Treasuries than versus swaps."

With the official Aug. 2 deadline fast approaching and Congress still divided about how to proceed, the talks will probably only be resolved in the last minute, if at all, the trader said.

"I think there's less of a chance of a default because the Treasury's going to be able to pay their debts, but I think a downgrade is a higher concern," the trader said.

Agency debt holders are hedging by selling benchmark issues and staying in cash, although even the act of holding cash can be tricky.

"How do you define cash?" the trader said. "Do you define it as a T-bill or a checking account? In our conversations with larger clients last week, they're not willing to go out even more than a month. If there's a default or downgrade, no one knows quite what the result will be."

Plunging confidence

The market had been confident that a deal would be done on time, because investors had bet that legislators would be frightened enough by the prospects of a U.S. downgrade to hash out a deal. But that confidence is eroding quickly.

"We've all been looking the other way until it's right in front of us," the trader said. "I told another trader today, for the first time there was a certain culpable sense of tension, and liquidity really started to come out of our market. Most of the retail accounts have moved to the sidelines, and those that had not may be picking and buying.

"But in the last 24 hours there's been some sense of selling as guys realized the reality of the situation, and you better get prepared for it," the trader added. "You can't just look the other way."

If the United States' credit rating is downgraded, the market could simply accept the lower grade and carry on as usual. Any downgrades could also be temporary if the deficit deal is eventually made.

"When people settle into the new norm, whether it's a temporary downgrade or they come through at the 11th hour, we will see intense buying," the trader said.

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