Agency spreads flat as volume spikes; Fed targets front end; heavy supply weighs on market

By Kenneth Lim

Boston, Feb. 3 - Agency spreads ended unchanged on Wednesday despite a pickup in trading volumes as high Treasury yields brought out the buyers.

The Federal Reserve Bank of New York announced that it will buy two- to four-year agency notes on Thursday, but the move was not seen as a key market mover.

After two days of widening, bullet spreads closed flat on Wednesday, said Mary Ann Hurley, vice president of fixed-income trading at D.A. Davidson & Co. Trading volumes were robust, with higher levels of trading earlier in the day.

"We were really pretty much flat across the board, although activity was pretty brisk," she said. "I think the widening out in the past few days, coupled with the higher Treasury yields just sparked some demand."

Callable issuance remained strong, Hurley added.

"Callable volume still seems to be pretty brisk with a lot of step-up issuance," she said.

Fed to buy at front end

The Fed said it will buy agency notes due February 2012 to January 2014 on Thursday as part of its outright coupon purchase program.

The purchases are expected to shrink as the Fed ends the program by March 31. The central bank has already bought about $164 billion of the $175 billion it is targeting.

Wednesday's announcement did not cause much of a stir in the market, which has already begun to price in the Fed's exit, Hurley said.

"We're getting near the end of the Fed's buyback schedule, which is supposed to end at the end of March," she said. "The announcement was expected, not really much of an impact."

Supply takes its toll

The market has been widening over the past two weeks, and the recent weakness may have to do with the strong supply coming from supranationals and sovereigns as well as from agencies, an agency analyst said.

"There's been quite a bit of competing issuance lately, and that's always a big factor," the analyst said. "There has been some pretty cheap stuff. We had Council of Europe, it was out today at 5 basis points over Libor...there's been quite a lot of this competition and a lot of it is cheaper than the GSEs, so it's hard for a lot of people to get excited about GSEs when there's stuff like that."

The government sponsored-enterprises have also been active issuers, the analyst said. Freddie Mac has been growing its debt, while there is some speculation that Fannie Mae may have to increase its outstanding debt as well in order to fund buyouts of delinquent mortgages.

"We're having a fair amount of GSE supply, although it's not in benchmark issuance," the analyst said. "We're seeing a lot of discount notes and callables."

The agency market is not rich at the moment in terms of spreads. Based on Tuesday's close, two-year spreads were only about 2 bps over Treasuries, while five-years are about flat with Libor.

"That's not rich," the analyst said. "Libor flat is kind of the breakeven for me between rich and cheap."

Spreads could tighten again if rates continue to go up, the analyst said.

"It's one of these things where I think they time their agency trading with overall rate levels and also spread levels," the analyst said. "It seems to be whenever rates go higher, you bring in a lot of buyers."

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