Agencies hold ground as Treasuries rally after Fed says inflation targets still not met

By Kenneth Lim

Boston, Sept. 21 - Agency spreads closed unchanged to a touch tighter on Tuesday, keeping pace with rallying Treasuries as the Federal Reserve strengthened its commitment to low interest rates.

Bullet spreads closed about 1 basis point tighter versus both Treasuries and swaps in the five-year and shorter sectors, said Janney Montgomery Scott chief fixed income strategist Guy LeBas.

Foreign buying picked up late Tuesday after the Federal Open Market Committee concluded its monthly meeting, LeBas said. The Fed issued a statement from the meeting, highlighting the central bank's concerns about deflation and leaving the door open for more quantitative easing.

"Spreads are a little bit wider on the long end," he said. "I think a lot of the foreign buying seems to have hit many portions of the curve."

The Fed's buying of Treasuries as part of its current quantitative easing program may also be helping agencies to stay close to Treasuries.

"There's some talk I've heard, that because the Fed is buying in Treasuries, some players want to stay out...so they buy agencies instead," LeBas said.

Fed says inflation still inconsistent

The Fed on Tuesday said it would leave the federal funds target rate at the current low of 0% to 0.25% "for an extended period."

"Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability," the FOMC said in a statement. "With substantial resource slack continuing to restrain cost pressures and longer-term inflation expectations stable, inflation is likely to remain subdued for some time before rising to levels the Committee considers consistent with its mandate."

The FOMC also said it will provide additional accommodation if needed to support the economic recovery and return inflation to more consistent levels.

The market pretty much stayed flat for most of Tuesday as investors waited for the FOMC statement. When the statement came out and Treasuries rallied, agencies managed to hold their ground.

"Spreads in general are pretty much unchanged," an agency trader said.

The result was that the agency market ended the day richer on an absolute yield basis.

"With the market rallying like it has, you saw a lot of action on the bid side, maybe some accounts coming in and taking some profit," the trader said. "But with the lack of any kind of spread widening and with rates moving lower, it's still kind of expensive out there."

Callables were also affected by the richening, and callable issuance could slow down on Wednesday.

"There was a ton of issuance before the Fed came out," the trader said. "Now everything has gone up, the price has been inflated. A lot of the cheap paper, in my opinion, the volatility pricing of the call option is a lot more expensive now, so tomorrow we're going to open up a lot richer."

Fannie Mae ahead

The market next waits for possible supply from Fannie Mae, which has a calendar announcement on Benchmark Notes scheduled for Thursday.

"The last thing I heard was probably a two-year," the trader said. That seems to be the best funding level of the curve."

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