Agencies narrow as Portugal concerns spark flight to quality; Fannie Mae supply ahead

By Kenneth Lim

Boston, Jan. 10 - Agency spreads closed slightly tighter on Monday amid light trading as concerns about European debt brought some safe-haven bids to the market.

Bullet spreads closed about 0.5 to 1 basis point tighter across the yield curve, a government bond trader said, with intermediate maturities underperforming slightly.

"I think there was a bit of a natural tightening after the widening that we saw last week," the trader said. "The stuff going on in Europe kind of pulled swaps wider, but agencies outperformed swaps because it made people buy dollar-denominated stuff."

But the outperformance by agencies came on a day with light volumes, and the lack of liquidity in the market took away much of the shine of Monday's tightening.

"There's not a lot of flow in the market right now," the trader said. "Coming into the new year everyone was kind of hoping for the market to come back with a bang after a very volatile December kind of kept a lot of people on the sidelines. But there's still a lot of uncertainty in the markets, and there's new issuance in corporates that's kind of diverting money from agencies."

The callable market was more active, with the run-up in interest rates over the past two months giving new issues attractive coupons.

"Callables are a little more exciting than bullets," said Mark Noble, head of agency at MF Global. "We had a pretty good move up in volatility the last two months."

Coupons remain attractive even though Treasuries have moved to the lower end of the range, Noble added.

"I think spreads are a little wider, and callables are clearly more attractive than bullets right now," he said.

Europe concerns revive

Investors flocked toward U.S.-dollar denominated safe havens on Monday as the market turned its attention toward the possibility that Portugal would be the next European country to come under pressure from debt markets.

The country is expected to raise capital this week, and investors were worried that a sale of debt by Portugal would not go smoothly.

"We saw concerns about the Europe and the Euro peripherals when we walked in, so there was a big sigh of relief," Noble said.

That relief also took off some of the pressure from this week's Treasury supply, with the government expected to sell $66 billion of debt in the next three days.

"I think more of the concern has been with peripheral issuance, and what's going on in Portugal is bigger," Noble said.

Fannie Mae supply ahead

Investors are also looking ahead to possible supply from Fannie Mae this week, Noble said.

Fannie Mae has as calendar announcement on Benchmark Notes issuance on Wednesday, and the consensus in the market is for an offering of two-year notes, Noble said. A three-year deal is also possible but may be a little less likely after Freddie Mac sold $6 billion of three-year debt a week earlier.

The agency will almost certainly focus on shorter maturities if it sells debt because of ambiguity about the future of Fannie Mae and Freddie Mac, Noble added.

"It's still going to be front-end deals," he said.

The Fannie Mae supply could bring some much-needed activity to the agency market.

"I think the dealer community is slowly putting their toes into risk taking as they start 2011," Noble said. "I think the next flurry of activity could be Wednesday with the Fannie Mae announcement."

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