Short-end agency spreads tighten, seven-years pressured; Fannie Mae could skip, trader says

By Kenneth Lim

Boston, Aug. 25 - Short-end agency spreads tightened slightly on Tuesday on a respectable auction of two-year Treasuries, but selling pressure was seen further out on the yield curve, market sources said.

On the primary side, the market is not expecting a big deal from Fannie Mae on Wednesday.

Two-year bullet spreads were about 1 basis point tighter following the sale of $42 billion in two-year Treasuries, an agency trader said.

"We did see some buying from the short end," the trader said. "We saw some two-year [Treasury] supply today. Swaps came in about 1.5 bps; two-year agency paper followed about 1 bps today."

Seven-year bullets ended the day slightly wider. Fannie Mae's 5.375% notes due June 2017 ended the day with a bid spread that was wider by 1.6 bps, according to data by Tradeweb.

"The seven-years today came under a little pressure," the trader said. "We saw some selling overnight from overseas accounts."

Overall volume remained light, and the day was "pretty quiet," the trader said. Callables also were not active.

"We were quiet in callables," the trader said. "There was some reverse inquiry stuff with [Federal Farm Credit Banks] and [Federal Home Loan Banks]. We've seen lots of step-up structures. People continue to do a fair amount of those."

Thomas L. di Galoma, head of U.S. fixed income rates trading at Guggenheim Capital Markets, said there was "very little volume going through" on Tuesday.

Border differences

Di Galoma noted that spreads were moving in anticipation of the end of the Federal Reserve's weekly purchasing program.

"We're starting to see spreads creep a bit wider," he said. "I think that the only natural buyer of agencies right now happens to be the Fed. There's still some buying out in Asia, but in the U.S. it's sort of the short callable with long maturity."

Overseas investors typically focus more on bullets, but domestic investors are doing more callables because they offer better returns, he said.

"You've got these 30-year, non-callable six months, that are being priced," di Galoma said. "Or 20-year, non-callable three months, and that seems to be the only way people can get some yield."

Callable investors take on the risk that the notes will not be called, he explained.

"What you're doing is looking for the issue to get called, and if it does get called, you have a way to go ahead and get a new one," he said. "If it doesn't get called, you hold it to maturity, and it becomes a bullet, but it's a good way of playing the optionality in agencies, which gives you a nice spread over where benchmark agencies would be."

Treasury auction relief

The Treasury's sale of $42 billion in two-year notes was seen as a solid auction, according to Cantor Fitzgerald head of fixed income rates strategy George Goncalves.

Despite a weaker bid-to-cover ratio of 2.68 times compared to the previous six auctions, Tuesday's offering received good indirect interest and priced well, he wrote in a note.

But Goncalves cautioned against reading too much into the auction because investors are trying to "squeeze extra yield and lock in carry" at the short end of the overall yield curve.

"The true litmus test for demand remains with duration products," he wrote. "Having said that, this August two-year has not upset the applecart, which means that tomorrow's five-year auction will be on its own with what happens next. We think that the tone in the market still remains govie bond friendly, which should help 5s and 7s more."

Fannie Mae announcement to come

Fannie Mae is scheduled to announce Wednesday whether it will issue Benchmark Notes, but the market is expecting a small deal, if any.

Di Galoma said that if Fannie Mae does not pass on the issuance, "it will probably be a new two-year, something short" because "that's where the demand is."

The agency trader said the market appears to be split over what will happen Wednesday.

"Probably two-thirds think they're going to pass, and one-third thinks they'll issue two-years," the trader said. "I'm in the camp that they won't do anything. They could reopen the three-year deal, but that's less likely. The most likely is they do nothing, next is they do new two-years, and the least likely is [they] reopen the three-years."

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