Agency spreads flat as Fed makes purchase offer; investors switch out to supra-sovereigns

By Kenneth Lim

Boston, Dec. 17 - Agency spreads were mostly unchanged on Thursday as investors began to wind down for the holidays.

Even the Federal Reserve Bank of New York's surprise decision to target the front end of the yield curve in a Friday purchase operation failed to move spreads in those sectors.

Bullets spreads were flat to slightly tighter on Thursday.

"Twos were in a basis point, 30-years in a basis point; [there was] some trading in callable papers," an agency trader said.

Volumes were noticeably thin with many accounts already wrapped up for the year, the trader said. The number of people still at their desks is also decreasing.

"It's year-end for almost everybody," the trader said. "Guys are done for the year. Why try to risk anything?"

Switching out of agencies

One trade that has been seen around the Street is switching out of agencies and into supranationals and sovereigns, the trader said.

"We're seeing more selling of agencies to buy supra, sovereign products," the trader said.

Certain institutional investors perceive a bargain in the supra-sovereign space because spreads there can be 10 to 30 or 40 bps cheaper than agencies, the trader said. But risk-wise, credit default swaps for the supra-sovereigns are pricing in smaller spreads.

"U.S. three-year CDs is around 32, France is 19, Germany is 12," the trader said. "If you're able to get them, sovereign protection at those levels makes sense. In a perfect world, those should be trading tighter than agencies, but they're not...Guys are saying that just doesn't make sense."

But the supra-sovereign paper can be difficult to get, and liquidity in the space lags behind agencies, so not many desks are doing the trade, the trader said. But those who can get their hands on the paper are focusing on the shorter end.

"It's mostly at the front end," the trader said. "There's no liquidity in the long end for sovereigns because they don't really trade. I think it's a good trade. It looks cheap on a Libor basis."

Fed surprises on purchase offer

The Fed said it will buy agency notes due December 2011 to December 2013 on Friday as part of its outright coupon purchase program.

The market had been expecting an operation further out on the curve based on past patterns, the trader said.

"That was a bit of a surprise there," the trader said. "The Street was expecting a long-end buyback. We got two-years to four-years...That breaks the pattern that they developed."

But the market hardly batted an eyelid, said the trader, who had sought but could not complete a trade to take advantage of the news.

"It had absolutely no impact on the market," the trader said. "I think that's just a function of there's nobody in...Normally it's good for 1 to 2 bps."

Due to the fact that the market is quieting down and the Fed has been shrinking the size of its operations, Friday's action should not be a major market mover either, the trader said.

"I would say I'd expect it to not be a huge buyback," the trader said.

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