Agencies widen as credit downgrades, Europe fears pressure spreads; FOMC meeting eyed

By Kenneth Lim

Boston, Aug. 8 - Agency spreads widened Monday as the market crumpled under credit rating downgrades and concerns about Europe.

After hitting wides early in the day, bullet spreads staged a late rally in the last 15 minutes of the session but still closed about 2 to 3.5 basis points wider versus Treasuries across the yield curve.

"I was just reading a story about an engineer for Air New Zealand who was working on an airplane engine and got sucked into it and died," a trader said. "That's pretty much today's agency commentary."

S&P cuts agency ratings

In a move that did not surprise investors, Standard & Poor's cut the credit rating for the government-sponsored enterprises on Monday to reflect its lowered rating for U.S. government debt.

The ratings for Fannie Mae, Freddie Mac, 10 of 12 Federal Home Loan Banks and Federal Farm Credit Banks were lowered to AA+ from AAA, in line with the U.S. government rating.

The lowered ratings, together with the reduced grade for the United States, threw the markets into disarray on Monday, with investors struggling to find a clear direction.

One puzzle was the widening of agencies versus Treasuries, given that the ratings of both asset classes were cut to the same extent. The answer may lie in the relative availability of alternatives.

"On some level, if the U.S. and agencies are downgraded, why should the spread relationship change?" the trader said. "This happened about one-and-a-half weeks ago, when the idea of a downgrade first came through. If you're a Treasury buyer, you're going to buy Treasuries anyway, and AA+ doesn't matter to you.

"If you're an agency buyer or spread buyer, you look at it versus other spread products and you realize agencies are now much richer, so you switch to something else."

Swaps also widened versus Treasuries, surprising the market given that swap spreads typically tighten when the credit rating of Treasuries is a concern.

"We're actually mixed against swaps because swaps got hurt so much later in the day we couldn't even keep up with that," the trader said.

Wider swaps could have been a result of investors expressing concerns about Europe despite the U.S. downgrades.

Fed meeting in focus

The Federal Open Market Committee has a one-day meeting on Tuesday, and investors are closely watching the meeting to see if the central bank will announce any new stimulus measures, the trader said.

"If the Fed does anything to step into this, any kind of nod to [a third round of quantitative easing]...that could be a turning point," the trader said.

Investors will also keep an eye out on developments in Europe, which have been keeping swap spreads under pressure.

"Long term I don't think the U.S. is a problem, but long-term I think Europe is a problem," the trader said.

But if the market does not find a positive headline, agencies are likely to remain depressed.

"We're going out with some weakness, which is not healthy," the trader said. "I would expect us to open lower tomorrow."

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