Agencies tighten as Fed stays the course, lets easing run out; callable notes rule the day

By Kenneth Lim

Boston, June 22 - Agency spreads narrowed slightly on Wednesday following a slightly hawkish tone to the Federal Reserve's latest policy statement.

Bullet spreads came in by about half to 1 basis point versus Treasuries across the yield curve, a trader said.

"We opened up this morning slightly wider, given the market rally and talk about what's gong on in Greece and the rest of Europe, then as the Fed made its statement, spreads narrowed back in," the trader said.

Trading activity was decent, but the market was slightly jittery given the uncertainties surrounding the Federal Open Market Committee's meeting.

FOMC stays the course

Yields initially slipped early in the day as the market backed off some of the initial enthusiasm surrounding the Greek government's vote of confidence for its prime minister.

Despite surviving the confidence vote late Tuesday, Greek prime minister George Papandreou still must get parliament to approve a new set of austerity measures in order to receive further aid and avert a default.

But attention around lunchtime turned to the Fed's meeting, and yields rose on expectations that the Fed would not add more monetary stimulus to the economy.

Following the policymaking session, the Fed essentially chose to maintain its current policy, saying in a statement that it would keep interest rates at the current lows for "an extended period."

"The slower pace of the recovery reflects in part factors that are likely to be temporary, including the damping effect of higher food and energy prices on consumer purchasing power and spending as well as supply chain disruptions associated with the tragic events in Japan," the Fed said in a statement.

The central bank will also let its $600 billion Treasury debt purchasing program run out as scheduled at the end of June.

"Everything leads me to believe that at least for the next three meetings or so no policy changes whatsoever will be made," the trader said. "But they didn't rule out QE3, which concerns me a little bit."

Behind the Fed's adherence to current policy despite a recent rash of weak economic data is the central bank's view that the economy's soft patch is only temporary.

"They think the unemployment rate is going to improve, which I don't see, but it's something they definitely addressed and they talked about, and their data shows it's going to improve," the trader said.

Callables rise above concerns

The one segment of the agency market that remains active is callables, where investors hope to pick up additional yield on the view that interest rates are not going to change anytime soon.

"People don't want to give up yield, but they're trying to shorten duration as well, so they're using call options to do that," the trader said.

A large amount of paper has also been redeemed by issuers in the low rate environment.

"In the last three weeks or so $50 billion to $60 billion of notes have been called, so even if you're not putting new money to work, you're just rolling $50 billion to $60 billion over," the trader said.

Callables are a decent buy as long as the Fed does not tighten its policy before the notes are called, the trader said.

"The only time you're going to get hurt is when the Fed starts to change policy, because the curve starts to change shape," the trader said. "Right now the cost to carry trade is big. You can't lever like you used to, but I can buy a two-year with a yield at 0.57%, and a one-year at 0.2%, which is double the yield, and in another year I'll just buy another one."

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