Agencies widen as Mexico deal pushes spread markets out; Fed purchases do little for front end

By Kenneth Lim

Boston, Sept. 18 - The agency market widened on Friday as a government deal from Mexico pushed spreads out, while the Federal Reserve Bank of New York's purchase operation was seen to have negligible impact.

Meanwhile, Barclays Capital analysts said they are now "cautious" about agency callables because they now expect that the Fed could raise short-term rates earlier than expected.

Bullet spreads moved out by about 1 to 1.5 basis points across the yield curve on Friday on light volumes, an agency trader said.

Callables remained active, as investors continued to seek better yields.

"Most everybody, with the downward move that we've had in long-term rates...with that and the fact that if the economy does turn in a year or two, people are looking toward the step-ups, the three-month, six-month calls," the trader said.

The trader said bullet spreads moved out along with most of the spread markets because of a $1.75 billion sale of bonds by Mexico. The country sold $1 billion of bonds due 2019 and $750 million of bonds due 2040.

"There was the Mexico deal that came, and it caused rates to widen out just a touch," the trader said. "That's also the reason the Treasury market was down."

Fed impact muted

The Fed on Friday bought $4.047 billion of one- and two-year agency paper as part of its weekly purchase program.

The amount acquired was 45% of the $8.993 billion of notes offered.

The move helped to bring spreads at the front end of the yield curve inwards on Thursday when the operation was announced because the Street had been expecting an action around the seven-year sector. But the operation's impact on Friday was insignificant, the trader said.

"It was mostly the front end of the curve, but spreads are already so tight there, there's not much room to get any tighter, so it really didn't affect much at all," the trader said. "It would have been more effective if they had done something in five-years, for example."

Shift on callables

With all the callable activity over the week, Barclays Capital analysts on Friday sounded a note of caution due to a change in the firm's views on interest rates.

"We move to a cautious stance on agency callables in light of our updated rates views," wrote analysts Rajiv Setia and James Ma in a note. "Longer-tenor callables look rich, and synthetic structures may offer better value."

Callables continue to offer more attractive yield compared to similar-duration bullets, the analysts wrote. But investors should add "only on a substantial backup in yields" because the firm now believes that the Fed will raise short-term rates in September 2010, earlier than expected. That rates forecast is based on expectations of a better economic recovery.

"Our cautious stance is premised on the view that yields are vulnerable to a large and sustained increase over the next few quarters, as the market starts to anticipate the advent of a Fed hiking cycle in late 2010," the analysts wrote.

Investors could however be opportunistic with regards to longer-term callables.

"We believe that we are likely to have a better entry point to buy callables in Q4 as the sell-off in rates gains traction," the analysts wrote. "In contrast to our predisposition over the past year toward shorter tenors, we would opportunistically look to add longer-dated structures, such as 10NC1s."

The agency trader was skeptical that a rates hike would come soon.

"I can't see that," the trader said. "I can see rates going up on their own, but I can't see them raising short-term rates. You try to go out there and get a loan, it's hard enough as it is."

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