Quiet agencies tighten modestly as Fed plan to keep low rates until 2013 lifts volatility

By Kenneth Lim

Boston, Aug. 9 - Agency spreads narrowed on Tuesday on extremely thin volumes as the Federal Reserve made an exceptionally accommodative statement.

Bullet spreads barely reversed Monday's widening, coming in across the curve on a little bit of yield hunting as Treasuries rallied.

"It's a little bit more than a reversal," said Mary Ann Hurley, vice president of fixed income trading at D.A. Davidson & Co.

The callable market was more active, with investors hoping to lock in higher yields.

"Activity in callables has increased, and actually throughout the yield curve people are buying stuff with longer call protection to protect themselves from lower yields," Hurley said.

Volatility sidelines investors

Trading volumes on Tuesday were exceptionally thin as the day's volatility discouraged big trades.

"We're going out now only marginally up, but the market's really illiquid," Hurley said.

Yields rose earlier in the day as investors pulled back from Monday's dramatic rally, helping agencies to recover some of their previous widening.

But the market reversed course in the afternoon after the Federal Open Market Committee said in a meeting statement that it would keep interest rates at zero to 0.25% range until at least mid-2013, the first time that the Fed has specified a timeline for the exceptionally low rate policy.

"The Committee now expects a somewhat slower pace of recovery over coming quarters than it did at the time of the previous meeting and anticipates that the unemployment rate will decline only gradually toward levels that the Committee judges to be consistent with its dual mandate," the FOMC said in its statement. "Moreover, downside risks to the economic outlook have increased."

Investors were surprised by the negative tone of the statement in relation to the state of the economy, and the assurance of low rates for the next two years helped yields to reach record lows.

"I've been pretty bearish on the economy, but even that really kind of exceeds my expectations," Hurley said of the FOMC statement. "I think them putting an actual date - and of course they can change it, but it's not what they're thinking - indicates that the economy is pretty weaker than expected and an exit strategy is not going to be embarked upon for a long, long time."

But as the session approached the close, yields rapidly pulled back as equities rallied and long-end Treasury supply loomed.

"We have just had an incredibly volatile day," Hurley said. "I think a lot of people were just waiting to sort it out and see how the market reacts."

FHLB likely to pass

Federal Home Loan Banks is expected to announce Wednesday that it will not use an issuance slot to offer new Global Notes, Hurley said.

"I'm hearing calls that it's most probably going to be canceled," she said. "The volatility is just really, really great."

The agencies have not issued new benchmark bullets since July 20, when FHLB sold $3 billion of two-year Global Notes.

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