Agency spreads narrow on Fed support, flattener trades; Fed could extend purchase program

By Kenneth Lim

Boston, Feb. 24 - Agency spreads tightened again on Wednesday as the longer end of the yield curve benefited from flattener trades and the Federal Reserve Bank of New York bought near the front end.

Bullet spreads were about 0.5 to 1 basis point tighter, said Mary Ann Hurley, vice president of fixed-income trading at D.A. Davidson & Co.

Another trader said longer-dated paper outperformed shorter notes.

"We did see a little bit of buying in the longer part of the curve," the trader said. "I expected to see a little bit more selling on the short end, just based off of the fact that we've had a good run in Treasuries, and you usually see a bit of selling on that...also you usually see some selling on the roll."

Agency debt at the long end had also outperformed other sectors on Tuesday, and the trader said investors were seeking bargains at that part of the curve.

"People are beginning to like the flattener again," the trader said. "And some of the cheaper things are in the longer part of the curve."

Looking ahead, Fannie Mae is expected to announce an offering of Benchmark Notes on Thursday.

"The consensus tomorrow is a two- or five-year," the trader said. "I think more people are leaning toward a five-year."

Fed buys at short end

The Fed on Wednesday bought $978 million of two- to three-year agency notes as part of its outright purchase program.

The amount that was bought was 30% of the $3.263 billion of notes offered.

"I thought it came about as advertised," said D.A. Davidson's Hurley. "But what the market participants are more interested in is to see if the Fed extends its purchase of both agencies and mortgage-backed securities pass the March 31 deadline."

The Fed will end the agency purchase program by March 31. The central bank has bought almost $166 billion of agency notes out of a possible $175 billion so far, and there are two more purchase operations left.

Hurley thinks the Fed is likely to extend the purchase programs because of the potential impact on housing markets.

"Certainly at this point the Fed is saying that they are going to wrap it up by March 31, but [Fed chairman Ben Bernanke] has made the point that they're going to be monitoring the situation," she said. "The last thing the Fed wants to see is mortgage rates going up.

"The housing sector is barely getting by right now...[and] any type of increase in mortgage rates would be very negative for the housing sector, and the Fed wants to make sure that that does not happen."

Volumes still weak

Despite all the tightening over the week, trading volumes have been anemic.

"I think it's a combination of people didn't really want to get in front of the Bernanke testimony that occurred this morning," Hurley said. "And levels are expensive...lower yields have just taken people out of the market."

A new week and a new month could give the market a jolt of life, she reckoned.

"I would think volumes will certainly pick up as we get past month-end," Hurley said. "And of course we always have the unemployment report at the beginning of the month, which is next week. So with unemployment upcoming that should certainly add to volume, but right now it's just extremely quiet."

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