Agencies widen as consumer prices, sentiment disappoint; Fed unlikely to add to purchases

By Kenneth Lim

Boston, Sept. 17 - Agency spreads eased out on Friday to end the week on a negative note as investors looked ahead to the next Federal Open Market Committee meeting.

Bullet spreads closed about 0.5 to 1 basis point wider on the day.

"Agency spreads were slightly tighter in the morning, then slightly weaker at the end of the day," said Gleacher & Co. trader Craig Ziegler. "Ten-year stuff finished maybe a half wider, five-year stuff was like one wider."

Volumes were quiet overall, although the morning was somewhat busier.

"There was better buying in the morning," Ziegler said. "After lunch the whole day just dried out."

Marx Bowens, head of U.S. Treasury and agency debt trading at CRT Capital Group, said agency mortgage-backed securities have also been under pressure over the past week amid signs that foreign central banks' holdings were declining.

"That was the one thing that caused spread widening," he said. "There was some speculation on the back of large callable issues being called, but that one gets recirculated back into the agency market. Maybe it's a timing issue."

Mixed week

Spreads also came under pressure after Friday's Consumer Price Index showed core prices unmoved in August, slightly worse than Street expectations.

Meanwhile, the consumer sentiment index fell to 66.6 in August, its lowest reading in a year.

On the week, agencies lagged Treasuries amid another busy week for corporate issuance. The yield curve steepened after the Bank of Japan's intervention to devalue the yen shifted demand toward shorter maturities.

Barclays Capital analysts Rajiv Setia and James Ma wrote in a note that Japan could target front-end agencies because Treasury yields are so low at the moment.

"It is worth noting that the previous intervention, in 2003-04, caused Japan's FX reserves to increase by roughly $375 billion, 85% of which ended up invested in Treasuries with little to none in agencies," the analysts wrote. "This time, however, we believe the lower level of yields may motivate the MOF to purchase higher-yielding Treasury surrogates, such as agencies.

"Although the magnitude of overall intervention is likely to be much smaller than in 2003-04, any marginal demand for agencies is likely to support valuations versus Treasuries in an environment where new agency supply is experiencing a secular decline."

Fed meeting in focus

The market is looking ahead to the Fed's meeting on Tuesday for possible indications of further quantitative easing, although market participants seem skeptical that the central bank will make a move at this time.

"I think they'll continue to reiterate that, based on the outlook, they will leave the door open for more quantitative easing if they have to," Bowens said.

Ziegler said: "Next week is all about the Fed meeting and quantitative easing. It's probably not going to happen then."

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