Agency spreads track swaps tighter to arrest week's slide; Fed buys $1.5 billion at front end

By Kenneth Lim

Boston, Jan. 22 - Agency spreads stopped their week-long widening late Friday, tracking swaps to nudge slightly tighter near the end of the day.

The Federal Reserve Bank of New York also helped near the front end of the yield curve, buying about $1.47 billion of agency notes as part of a purchase program.

Bullet spreads ended the day "slightly tighter," said Christopher White, senior vice president of fixed income sales and trading at Moors & Cabot Capital Markets. Agencies in general outperformed corporates, which widened because of "a little bit of a fear trade," he said.

Two-year Fannie Mae 0.875% notes due January 2012 closed at a spread of about 14 basis points, wider by about 0.5 bps.

"Spreads were better bid by the end of the day," he said. "Swaps were in by about 3 bps, and the Fed announced late yesterday the next purchase operation."

The primary market saw two large issues by Federal Home Loan Banks, which sold about $3.5 billion of TAPs, but it was otherwise dominated by smaller offerings.

"We had a lot of choppy small deals...there's a lot of supply, but again the market's a pretty good sponge right now given that the risk trade is kind of unwinding a little bit," White said.

The Fed on Friday also helped to support the front end of the curve by buying $1.47 billion of agency notes through its open-market purchase operation.

The amount that it bought was 30% of the $4.906 billion in notes offered for sale. That acceptance rate was in line with the previous week's action.

Split market

White said there was an interesting disparity between 10-year on-the-run and off-the-run spreads.

"At the 10-year part of the curve, you've seen 10-year Reference Notes trading as tight as 19 bps [over Treasuries], although now they're +21 bps, which is significantly tighter," he said. "But you can buy off-the-runs at +48 bps."

The off-the-run issues are much smaller deals and less liquid than the on-the-run paper, but the prospect of higher yields in a rich market has been tempting for some investors, he said.

"I have customers coming in and historically they would just buy Benchmarks or Reference Notes, and they're now going down the liquidity chain and getting much higher yields," White said.

The difficulty in finding the less-liquid off-the-runs has been limiting the use of the trade, but prices in off-the-runs have already been affected.

"There's only so much out there in the small deals, but the off-the-runs have tightened by about 8 bps in the past week in 10-years," White said.

Uncertain markets

The spread outlook for the coming week is tough to call given the new uncertainties in the markets that led to a sharp drop in equity prices, White said.

"It's very difficult to tell given that we've had a 500-point loss in the equity market," he said.

If investors remain concerned after the weekend, agency spreads could widen against a surge in Treasury prices, White said.

"I would think you might see a Treasury rally and agencies lag if there's a flight to quality situation," he said. "You will see prices appreciate, but spreads will lag. Something that's +22 bps to [three-year Treasuries] today may be +25 bps next week."

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