Agency spreads widen on profit taking, FOMC news; Fed to target on-the-runs in early operation

By Kenneth Lim

Boston, Sept. 2 - Agency spreads widened on Tuesday as investors took profit and the Federal Open Market Committee said its members recently discussed ending its purchasing program.

The market was also watching to see how the Fed's weekly purchase operation will perform on Thursday, a day earlier than usual.

Bullet spreads were unchanged in the short end of the yield curve, but wider by about 2 to 3 basis points in the five-year sector, an agency trader said. In 10-years, the spreads expanded by about 3 to 4 bps.

"We probably saw a few more accounts coming in looking to sell into the rally, and we saw spreads move out a little bit," the trader said. "It was a combination of people looking to take some gains and the FOMC talking about the agency purchases coming to an end."

In its August meeting, FOMC members discussed tapering the Fed's open-market purchasing operations of Treasuries, agencies and agency mortgage-backed securities, according to minutes released Tuesday. The Treasury purchasing program has already been extended to the end of October to progressively reduce the buying in that market.

The Fed has already bought about $117 billion of the $200 billion allowed under the program, which ends with the year.

"A number of participants noted that a similar tapering of agency debt and MBS purchases could be helpful in the future as those programs approach completion," according to the minutes.

The trader said "spreads were wider on the longer end, and that's what happens when the Fed says, 'OK, we're going to end the buybacks.'"

Fed to buy at short-end

The Federal Reserve Bank of New York will buy two- to four-year agency notes on Thursday, according to an official announcement.

Included in the list of paper being targeted are the Freddie Mac 2.125% notes due September 2012, which were reopened for an additional $1 billion on Tuesday and would not have been eligible for purchasing before the Fed this month expanded its buying program to include on-the-run securities.

The announcement came a day earlier than usual, with the Fed usually revealing on Thursday its purchasing plan for Friday, which some in the market said may be because of the coming Labor Day weekend.

"It will be very interesting to see tomorrow's reaction," said Michael Graf, head of U.S. agency trading at Barclays Capital, adding that he would be looking to see how much of the new issues they buy.

Graf said he expects that investors will be enthusiastic about the opportunity to sell to the Fed.

"They'll be offered a pretty good amount," he said.

On-the-runs on target

Thursday will be the first time that the Fed will buy on-the-run agency securities under the purchasing program.

The Fed on Tuesday explained its decision to target on-the-run securities as "a technical adjustment designed to mitigate market dislocations and to promote overall market functioning."

Graf said the change should not have been a big surprise, although the market was initially "caught off guard."

"I think the immediate reaction from the Street was that they were caught off guard," he said. "The dealers got very complacent with buying seasoned benchmarks and hedging with the on-the-runs. The Fed purchased the seasoned issues and the dealer traded around the short. With this change the Fed will again be buying what the Street is short and thus the rally in spreads. It will take time for this imbalance to work through."

An agency analyst said the previous policy in which the Fed just targeted off-the-run securities created a situation where "everyone would buy a new issue because they figured the Fed would buy it a month down the road."

"It was great because it helped Fannie Mae and Freddie Mac to sell new issues," the analyst said. "Those who bought would make a good spread profit."

But the policy was reaching a point where the Fed was running out of paper to buy, the analyst noted.

"They recently hit 50% on some 2013 or 2014 maturities, and I think they stop buying them when they hit 50%," the analyst said.

The Freddie Mac 2.125% notes due September 2012 is a good example of a big series that the Fed would prefer to buy but would not have been able to under the previous policy, the analyst said.

"It's a good size issue, and they can conduct an entire purchase operation there alone and be happy," the analyst said.

But the analyst said the impact may not be that significant on the market.

"Opening yourself to on-the-runs only opens you up to about four new bonds," the analyst said. "I'd be more interested if they were buying discount notes and callables."

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