Agencies tighten as Fed to buy shorter paper; rest of year could see widening, analyst says

By Kenneth Lim

Boston, Aug. 20 - Agency spreads finally tightened Thursday after widening for most of the week, but analysts say they expect expansionary pressure to persist in the days and weeks ahead.

The Federal Reserve Bank of New York also announced that it will target one- to two-year agency paper in its weekly Friday buying program.

Agency spreads were about 2 basis points tighter in the two- to five-year sector on Thursday, but the move was seen as less of a firm contraction and more of a slowdown in recent widening, said Thomas Urano, principal at Sage Advisory Services.

"It's just one or two [basis] points tighter, when the bid-ask spread is three or four [basis] points," he said.

Despite the recent widening, yields at the front end of the yield curve are in the low double-digits, which is rich unless "you can get something out of the supply," Urano said. The overall yield curve remains "extremely steep" and a number of investors have implemented "rolling" strategies to go further out on the curve, he added.

The five-year sector could hold the most value, he said.

"We kind of like, overall, the five-year part of the curve best in general, not just in agencies," Urano said.

Fed targets short end

The Federal Reserve said that it will buy agency securities due 2010 and 2011 on Friday as part of its weekly purchasing program.

The Fed last bought $259 million of two-year paper in a $3.235 billion action on July 24. Its last purchase action that focused only on one- to two-year agency securities was on July 10, when it bought $3.873 billion.

An agency analyst said the Fed purchases will most often be closer to the front end of the yield curve simply because about 70% of outstanding agency debt matures before 2013. The market could look at Friday's purchase for clues on how aggressive the government will be in supporting the agency market as its purchasing program heads into its final months.

"The numbers tend to be in the $3 billions to $4 billions," the analyst said. "If it's a small number like one-point-something billion dollars, the market will be worried. But if it's a large number, the market will say they're still being aggressive."

The accepted-to-offered ratio has declined in the past few purchases even though the Fed is behind schedule in buying the targeted amount of agency notes, leading some market observers to suggest that the Fed could be wavering in its commitment to the program. But the analyst said that the accepted-to-offered ratio may not be a useful gauge.

"If you were a dealer and you were short agencies versus Treasuries, and you wanted spreads to widen, would you offer $4 billion at 2 bps over the market?" the analyst said. "The market can adjust how much they offer and influence that ratio in that favor...I think it's more useful to look at the raw size."

Final purchases

The recent widening in agency spreads may have been due in large part to investors anticipating an end to the Fed's purchases, the analyst said.

The Fed is authorized to buy up to $200 billion of agency debt until the end of 2009, and currently holds about $111.8 billion in its System Open Market Account.

"They still have $80 billion to $90 billion of agencies to buy in the market. No doubt the market is really starting to wonder what will be the next phase?" the analyst said.

The analyst noted that two-year agency spreads were in the 170 to 180 bps range before the buying program was announced in 2008 after Freddie Mac and Fannie Mae were placed under conservatorship, and spreads are now in the 20s.

"The conservatorship didn't do the trick...you can see why the market would say, if the Fed's leaving, we could go back to where the market was before," the analyst said.

The U.S. government is expected to announce in February 2010 plans for the future of Freddie Mac and Fannie Mae, and until then, investors may be slowly exiting agencies to wait out in supra-nationals, Treasury bills or corporates.

"You want to exit the market when the Fed is exiting the market," the analyst said.

Continued pressure

Agency spreads could continue to widen also because of the fact that rates in general are lower.

"A lot of people in agencies buy based on where the yield is right now," the analyst said. "I think the yield levels having declined, people are just saying, this is, A, a great time to get out of the market, and B, just to get through the next three months because nobody knows what's going to happen."

The market could continue to see spreads softening as the year-end approaches, the analyst said.

"I think spreads will widen a little bit...This will hurt spreads for the next month or two, but I don't think we'll see panic levels," the analyst said.

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