Agency spreads narrow as Fed plans to cut buying frequency; Fannie Mae eyed for direction

By Kenneth Lim

Boston, Feb. 23 - Agency spreads narrowed slightly on Tuesday as the Federal Reserve Bank of New York said it will buy two- to four-year agency notes this week.

Trading volumes remained sluggish as investors try to digest the end of the Fed's purchase program, and an announcement by Fannie Mae on Thursday could offer some guidance on the supply outlook.

Spreads were about 1 to 1.5 basis points tighter across the yield curve on Tuesday, although five-year spreads closed unchanged, said Mike Goldman, head of agency trading at Guggenheim Partners.

"The long end, 10-year sector has traded better," he said.

Callable issuance remained strong, Goldman said.

"It still continues humming along," he said.

A second straight day of low volumes put a damper on the market.

"We've had a couple of extremely quiet days," Goldman said. "Sometimes you get a market where dealers just move things around a bit...We're in the middle of a range, I think."

Fed to slow purchases

The Fed announced plans to cut the frequency of its purchase program, which ends by March 31. The central bank also said it will buy agency notes due March 2012 to January 2014 on Wednesday.

The purchase operations will now take place every two weeks instead of weekly, which suggests that the Fed is only planning two more purchases - in the weeks of March 8 and March 22. The Fed said it "may alter this practice as market conditions warrant."

The government's exit from the agency market has long been anticipated by the market, but it is still a key uncertainty that is keeping spreads in a range, Goldman said.

"The Fed's on the way out now," he said. "The question is, is the market, are customers going to step in? I don't think so."

Goldman thought that it was possible to see the amount of paper offered to the Fed increase as investors try to take advantage of the willing buyer one last time.

"There are only two or three left, maybe we sold the last five-years last week," he said. "You don't want to be left out. It's like musical chairs, right?"

All eyes on Fannie Mae

The market may see a pickup in activity on Thursday when Fannie Mae announces whether it will issue new Benchmark Notes, Goldman added.

"We may get a little bit of direction from Fannie Mae on Thursday when they announce," he said. "If they announce a new five-year, people may say, 'Hmm, they may still have some needs here.'"

Most investors are expecting a reopening in the two- or three-year sector, although a five-year deal could also be possible because Fannie Mae has not issued new five-year Benchmark Notes since a $3.5 billion deal in October 2009.

"Freddie Mac has had the five-year sector now for three months," Goldman said. "Freddie Mac is really the active issuer here. Fannie Mae's is old. I think they might want to get a five-year out there for the exposure, if you will."

An unexpected five-year deal could lead to some widening if investors perceive more supply than they had predicted, he said.

"I think it will cause the market to flinch a bit," Goldman said. "We're kind of caught in between here. There's no reason to widen, but if you get that deal we might see some widening...We're waiting for the other shoe."

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