Agencies well bid on buyback, month-end, trader says; supply to stay tight, strategist says

By Kenneth Lim

Boston, June 30 - Agency spreads tightened by about 2 to 5 basis points across the yield curve on Tuesday amid buybacks by the Federal Reserve Bank of New York and month-end activity, as the market closed the second quarter expecting supply to decline.

Agencies were "very well bid" on Tuesday as spreads contracted across the board, an agency trader said.

"We saw continued buying across the curve on the Fed buying program," the trader said. "We also saw month-end expansion, saw a lot of month end-related buying."

The New York Fed on Tuesday said it bought $1.2 billion of agency paper due 2016, 2017, 2018, 2030, 2031 and 2032.

Tightening quarter

The second quarter saw "pretty massive tightening" of spreads because of the Fed's buyback program and expectations of reducing portfolios at Freddie Mac and Fannie Mae, an agency strategist said.

In the first quarter, those two agencies had some large new issues, leading to a belief that they were bulking up their mortgage portfolios to push down mortgage rates, the strategist said. But the Fed buyback and rising delinquency rates have made it apparent that Freddie and Fannie are in no great need to raise funds, the strategist explained.

"It's become obvious, as their delinquency rates continue to rise, that they don't need to raise as much," the strategist said. "They're still on the operating table. They're not ready to go out."

Declining supplies ahead

The amount of available agency paper is likely to continue to evaporate in the second half of the year, the strategist said.

Fannie Mae's scheduled Benchmark Notes announcement on July 8, if it is not skipped like the two in June, will probably be a small deal, the strategist said.

"Maybe they'll pass, maybe they won't, but it's probably going to be a $3 billion to $4 billion two- or three-year note or something like that," the strategist said.

The agencies will also be reducing their portfolio sizes, by 10% per year beginning 2010 to an eventual target of $250 billion each, as part of their coming under the conservatorship of the Treasury. And the end of the year could see supplies dry up at a hastened pace as lenders refinance their mortgages.

"I think we'll go into runoff mode before January, so that's going to be even more friendly for debt," the strategist said.

The days of growing portfolios to raise stock prices are also probably over at Freddie Mac and Fannie Mae, the strategist said.

"I don't think they're going to be running that way anymore," the strategist said.

Fed-supported demand

The Fed will continue to be the main demand driver as it buys back agency paper, the strategist said.

"Demand is really driven by the Fed's demand," the strategist said. "If the Fed said tomorrow they're not buying any more agencies, I think demand is going to fall off quite a bit."

But spreads can only tighten by so much, the strategist said. Shorter-term paper will probably hit a floor of about 10 basis points over Treasuries if Treasury yields remain low, beyond which investors will simply choose the safer option. If Treasury yields are higher, the spread floor will also increase.

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