Agencies lag Treasuries, swaps as market retreats from recent tights; FOMC, supply ahead

By Kenneth Lim

Boston, Aug. 9 - Agency spreads widened on Monday as investors continued to back away from recent tights.

Bullet spreads were particularly weaker on the front end of the yield curve, where valuations were exceptionally cheap a couple of weeks ago, said Guggenheim Partners' head of agency trading, Mike Goldman.

Two-year spreads closed around 16 basis points over Treasuries on Monday, considerably wider than the 9 bps spreads from two weeks ago. Five-year spreads have held up a bit better, widening to about 23 bps from 19 bps in the same period, Goldman said.

"We're entering a period of spreads leaking wider, certainly in some of the overvalued sectors" he said.

The long end of the curve was unusual, with 20-year agency spreads looking cheap relative to Treasuries because 30-year Treasuries have been underperforming significantly in the past week.

"There's been such a steepening of the curve between 10s and 30s that they actually lag," Goldman said.

Trading volumes were quiet with the market slow to come back to life after the weekend.

Trailing swaps

The market underperformed swaps as well on Monday, adding to the lackluster start to the week for agencies.

"I think it's a little bit disturbing because five-year swaps and 10-year swaps were tighter on the day," Goldman said.

The market's struggles actually began before Friday's disappointing payroll numbers sparked a flight toward safer Treasuries, the trader added.

"I think the trend had been in place already...the general theme clearly in the short to intermediate term has been widening spreads," Goldman said.

Fed, supply ahead

The week ahead will be dictated to a large part by the Federal Reserve's Federal Open Market Committee, which will meet Tuesday.

There is a possibility that voting members will restart the Fed's quantitative easing program to inject some stimulus into the markets, although the central bank will probably not target agency debt again.

The inclusion of agency debt in the first quantitative easing program through 2009 and the first quarter of 2010 was mostly to keep this market in line with agency mortgage-backed securities, Goldman explained. But the need for such manipulation is no longer present, he added.

"I think if there is another round of QE, I'd be very, very surprised to see it involve agencies," Goldman said.

But a new buying program that targets Treasuries could put widening pressure on agencies "to the extent that it moves Treasuries tighter," Goldman said.

Federal Home Loan Banks could also add to supply this week with a calendar announcement on Global Notes scheduled for Wednesday.

"I think people are hoping that they do something," Goldman said. "My best guess is threes or fives. They haven't done much in fives, but they're shortest in that sector and I think people are really hoping that they do a five."

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