Agency front-end spreads narrow on Fed purchase; Fannie Mae could sell two- or three-years

By Kenneth Lim

Boston, March 8 - Agency spreads tightened slightly at the front end of the yield curve on Monday as the Federal Reserve Bank of New York announced a purchase operation in the one- to two-year sectors.

Bullet spreads were seen about half a basis point narrower at the short end of the curve.

"We saw buying at the one- to two-year part of the curve," said Mark Noble, head of agency fixed-income trading at MF Global.

Trading volumes were lighter than before the weekend in anticipation of $91 billion of three-, 10- and 30-year Treasuries later in the week.

"Today in general the market was a little bit slow," Noble said. "In the fixed-income markets this week all eyes are on Treasury supply."

Fed targets front end

The Fed said it will buy agency notes due March 2011 to March 2012 on Tuesday as part of its $175 billion purchase program, which will end by March 31.

The Tuesday operation will be the second-to-last one by the Fed, which has already bought about $167.5 billion of agency debt.

The purchases are usually carried out later in the week, but the Fed may have decided to do its buying earlier this week in order to avoid getting tangled up with Fannie Mae's calendar announcement of Benchmark Notes issuance on Wednesday, Noble said.

"It's better to announce the buybacks today for Tuesday," he said.

The Fannie Mae deal will mostly likely be a reopening in the two- or three-year sectors based on current funding costs, Noble said.

"Libor in five-years is the least attractive, so I would expect a reopening of two-years or three-years."

Uncertain month

The looming end of the Fed's purchase program is a major uncertainty facing the agency market this month, but recent comments by U.S. Rep. Barney Frank on Friday also added to investors' concerns, Noble said.

"There's a lot of uncertainty in the month of March," he said.

Frank said on Friday that he does not believe that agency debt should be guaranteed by the federal government and raised the possibility that holders may have to take a haircut eventually. That was seen by investors as a troubling reversal of existing policy, and the Treasury quickly reiterated its full support for Fannie Mae and Freddie Mac. Frank also later clarified his statement.

But the damage was done on Friday, when spreads widened shortly after the comments were published.

Noble said the ongoing confusion could lead to widening spreads. Treasury's support for Fannie Mae and Freddie Mac in the next three years appears to be strong, but a longer-term policy is still up for debate.

"I am not comfortable with long agency spread versus Treasuries with all the possible tape bombs that could be hitting the newswires and with the Fed planning on stopping their buyback program on March 31," Noble wrote in a note to clients.

Investors who want to be long on agencies should pick callables over bullets, front-end bullets over long-end bullets and Federal Deposit Insurance Corp.-backed debt over agency debentures, Noble suggested.

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