Agencies underperform Treasuries on Greece, Portugal downgrades; callables activity quiet

By Kenneth Lim

Boston, April 27 - Agency spreads widened on Tuesday as swaps came under pressure following credit rating downgrades for Greece and Portugal.

Bullet spreads performed the worst at the front end of the yield curve, expanding by about 4 basis points in the two-year sector. The rest of the curve shifted out by about 2 bps.

"With swap spreads wider, we got hammered as well," an agency trader said.

Trading volumes were weak amid the uncertainty surrounding the Greece issue, and most of the money moving in the markets was headed to the safe haven of Treasuries, the trader said.

"Flows have been really, really light," the trader said. "Guys are just dealing with the rating downgrades this morning."

Greece, Portugal hit spreads

The trader said the widening on Tuesday was partly a result of rich swap levels.

"Libor's been grinding higher for weeks now," the trader said. "I don't know why that's a surprise for the market, but it looks like the market was just waiting for an excuse to sell."

Standard & Poor's downgraded the debt of Greece to junk and Portugal's to A- from A+, citing the countries' problems in meeting their debt obligations. Those countries' problems could leak into the rest of Europe and affect rates, the trader said.

"If there's a problem in Greece, it will spill into Europe, and they're like two-thirds of the Libor committee," the trader said.

But the "old-fashioned flight to quality" trade was also a key factor, the trader said. The reaction was strong enough on Tuesday that short-term agencies, which enjoy strong backing from the U.S. government, also came under pressure.

"When it's a real flight to quality, they don't want any spread products," the trader said. "Short-end agencies got hit the hardest...It's a mechanical thing. Short end agencies aren't going to do well if the euro doesn't do well."

Callables slow down

Callable action also took a hit on Tuesday because the widening spreads offset the higher volatility, taking away some incentives for making new trades.

"There was surprisingly little buying in new issue callables," the trader said. "Spread widening takes out a lot of moves, while volatility is up, so it doesn't really matter that Treasuries are lower in yields."

The callable market could come back strong on Wednesday if agencies tighten while Treasury yields hold firm, the trader said.

"If tomorrow we get Treasuries holding a chunk of the rally today, you'd expect to see agencies come back a little, and callables should move pretty well," the trader said.

Market expectation is that Treasuries will trade up again overnight, the trader added.

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