Agency spreads narrow on pause in Treasury rally; markets await European developments

By Kenneth Lim

Boston, May 7 - Agency spreads tightened slightly on Friday as investors finally took a break from their relentless pursuit of Treasuries.

Front-end bullets outperformed longer-dated paper, said Ted Ake, managing director of U.S. Treasury and agency trading at Societe Generale.

"Spreads ended just about unchanged to maybe a little bit tighter," Ake said. "We've had a decent bid all day, despite the fact that swap spreads were under pressure."

Floating-rate agency debt had a strong day, as investors perceived a higher probability of a liquidity crunch.

"Floaters are doing pretty well here, so agency floaters are in pretty high demand," Ake said, "because we could be facing the liquidity issues that we faced in the middle of 2008."

Callable issuance, however, remained thin amid the high market volatility.

"It's kind of a quiet day [for callables]," Ake said. "[There were] only a few small deals, which makes sense. With all the volatility we've seen, buying callable debt is usually not done under these circumstances."

Agencies continued to perform better than swaps, which have been taking a beating over the past week as the concern level about Europe's debt crisis grew.

"The market held a better bid than some of the other spread markets," Ake said. "You can see swaps were out wider. Obviously the equity markets were rather weak."

Risk-driven volume

The agency market had been quiet for most of the week as investors fled to the safety of Treasuries and other risk-free instruments.

"Whenever you have high periods of volatility, agencies aren't the place people are going to immediately run to," Ake said. "They go toward safety."

But agencies will be one of the first markets to benefit if investors feel comfortable with venturing into some spreads, he added.

"It's when things calm down that they go to the agency market first... then they move out the credit curve," he said. "So for the next couple of days, as we face this high uncertainty and volatility, you're probably not going to see a lot of interest."

The investor base that supports agencies has also shrunk.

"There's been a lot of bad press on [Fannie Mae] and [Freddie Mac], so the market has lost a lot of those customers," Ake said. "A lot of Far Eastern accounts have gone, and a lot of them have not come back. The core agency buyers...investors that are looking for high-grade paper and better yields, they're still here, but they are waiting to see what happens."

Nervous weekend

Investors enter the weekend worried about Europe's debt problems, with "nerves" being the main sentiment, Ake said.

"We've got all our positions here as close to flat as we can get," Ake said. "We've been running over scenarios here at the trading desk. If they do something over the weekend the market should be significantly lower and flatter. If they don't do anything over the weekend, the market could be significantly higher and steeper."

How spreads move next week "depends on how much the regular markets calm down," he added.

"If they come with a decision that can calm down the market, you should see agency spreads collapse," Ake said. "We could probably narrow 3-5 bps really quickly, then grind in tighter after that. But there's still so much uncertainty."

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