Agencies end mixed as front end sees resistance, long end comes in after Bernanke comments

By Kenneth Lim

Boston, July 21 - Agency spreads closed mixed on Wednesday as investors poured into Treasuries following discouraging remarks by Federal Reserve chairman Ben Bernanke.

"Agencies are doing very well as we continue to see buying in the Treasury markets," an agency trader said. "People are still looking for agencies. No matter how rich they are, they're still cheaper than Treasuries, so people are still buying them."

The two-year agency spreads widened by about 1 basis point, while spreads five years and out came in by about 1 bp.

The two-years' underperformance was mostly resistance to spreads getting tighter in that sector, the trader said.

"[There's] just kind of a sticker shock," the trader said. "It's very tight in that part of the curve. Two-year agencies may be 16 bps over or so...guys will probably fight that for a while."

Trading volumes were robust, especially in the afternoon after Bernanke's testimony. Buying of callable paper was also heavy, the trader said.

"[There's] more buying in agency callables," the trader said. "Guys keep reinvesting the money that's been called."

Bernanke sparks buying

The market picked up its furious buying on Wednesday after Bernanke struck a cautious tone in testimony before the Senate Banking Committee.

"Even as the Federal Reserve continues prudent planning for the ultimate withdrawal of monetary policy accommodation, we also recognize that the economic outlook remains unusually uncertain," he said.

The Fed chairman said the economy does not appear to be heading for another contraction, but he left the door open for the central bank to pursue monetary stimulus again if necessary.

Howard Simons, a strategist at Bianco Research, said Bernanke's remarks came as a surprise in its tone.

"I think when Bernanke goes up there and says, 'Hey, this is pretty strange, I really don't know what to do,'...that doesn't instill a lot of confidence," Simons said.

The testimony on Wednesday raised serious fears about the economy's outlook, he added.

"The simple fact of the matter is I'm getting alarmed at how some of these economic metrics are deteriorating," he said. "It's like falling off a cliff."

Agencies ride coattails

Agencies benefited from the flight to quality on Wednesday, the trader said.

Treasury yields were being pushed so low that investors were happy to buy agencies if they could just to pick up some extra return, the trader said.

It helped that swaps have also been tightening. Combined with lower volatility, tightness in swaps has helped to support agency spreads.

"No matter how rich they are versus Treasuries, it still looks a little cheap given the richening in Libor," the trader said. "There's value versus Libor...I don't see anybody willing to sell."

The fact that agencies continue to form a significant portion of government bond indexes is also driving spreads ever tighter.

"There's too much pent-up demand," the trader aid. "Agencies are still a large portion of the index."

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