Agencies keep pace with Treasury rally; investors neutral ahead of debt ceiling deadline

By Kenneth Lim

Boston, July 29 - Agency spreads stayed flat on Friday as investors clung to the sidelines as a downgrade-averting budget deal remained out of sight.

Bullet spreads closed unchanged on the day, hovering around the same levels at which they started the week.

"Spreads have held pretty constant all day," an agency trader said, noting a "very, very thin market and not so much underwriting.

"Everybody was very reluctant to get involved with the uncertainty over the weekend," the trader said.

The callable market, which would normally draw interest as defensive instruments, was also quiet.

"We got some business done today, but to be honest with you, without the House even voting last night, everybody just threw up their hands and went into wait-and-see attitude," the trader said.

Yields fall

Yields tumbled Friday on heightened expectations that U.S. lawmakers would not be able to reach a deal that adequately cuts the budget deficit as well as raise the debt ceiling in time to avert a downgrade of the country's Aaa rating or a default on its debt.

Although the absence of a deal could lead to a downgrade in the ratings of U.S. government-backed debt, the thinking in the marketplace was that the resultant burden on the economy and limited supply would still boost Treasury prices.

The House of Representatives was supposed to vote on a Republican-led proposal late Thursday, but the vote was postponed when it seemed like House speaker John Boehner would not be able to secure enough votes from his own party. The Democrats, who control the Senate, have also begun to pursue their own plan, raising doubts that Washington would be able to compromise before a theoretical Aug. 2 deadline.

"Treasuries have just taken off very dramatically, which is making it more difficult to get deals done," the trader said. "Believe it or not, we saw volatility come down some in swaption volatility."

Investors spent the day trying to do as little as possible, given that the end of the month nevertheless forced some accounts to make some trades.

"It was mostly a very defensive day," the trader said. "People were just buying because of month-end, and trying not to get overly involved in the marketplace."

Economic numbers disappoint

Yields were also depressed by a surprisingly weak gross domestic product report.

The country's GDP rose just 1.3% annualized in the second quarter, while first-quarter growth was revised sharply lower to 0.4% from 1.9%.

"Oh my god," the trader said. "How bad was that?"

The dim economic outlook and the murkiness about the debt ceiling debate combined to leave investors struggling to understand how best to position themselves in the current market.

"There's really not any good way to really hedge this stuff," the trader said.

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