Agencies underperform as S&P cuts U.S. debt outlook; yield curve steepens; swaps narrow

By Kenneth Lim

Boston, April 18 - Agency spreads widened slightly on a volatile Monday and the yield curve steepened on the back of Standard & Poor's downgrade of the United States' debt outlook.

Bullet spreads eased by about half to 1 basis point versus Treasuries across the yield curve, an agency trader said. One possible bright spot was that the selling was not worse than it was.

"It was not wholesale selling of product," the trader said. "I think people saw opportunities to buy product on any sell-off."

S&P downgrades U.S. outlook

Credit ratings agency S&P on Monday cut its outlook on U.S. debt to negative from stable, indicating a 33% chance of a rating change within two years. U.S. debt is rated AAA by S&P.

The ratings agency cited the risk of lawmakers not being able to address mounting budget deficits for the move by 2013.

The news initially sent yields climbing early Monday, before Treasuries staged an afternoon comeback to end on lower yields.

"The rebound in the Treasury market in the afternoon was kind of a refutation of that [S&P] concern," the trader said. "That being said, they [S&P] are probably right."

Agency spreads ended the day underperforming swaps as well, because swaps tightened significantly versus Treasuries on the change in credit quality.

"We certainly underperformed versus Libor," the trader said. "If Treasuries cheapen on credit quality, they're going to cheapen versus swaps."

Guy LeBas, chief fixed income strategist at Janney Montgomery Scott, said agencies lagged swaps by 3 to 7 bps across the yield curve.

"Agencies underperformed by a wide margin," he said. "It wasn't a very good day for agencies."

Yield curve steepens

The yield curve steepened, albeit not without a lot of movement, which was expected because concerns about U.S. credit quality would affect longer maturities more than shorter-term paper.

"It was a volatile day to say the least," LeBas said, noting "some very mixed directions with spreads, both intraday as well as end-of-day. The key thing is the credit curve steepened a little bit."

LeBas said the five- to 10-year part of the curve saw the most steepening, while the 10- to 30-year spread did not change much.

"We expect the yield curve and credit curve across the board to steepen between five- and 10-years," he said.

LeBas said the effect of the S&P downgrade will last until S&P changes its outlook on the rating again.

The trader said that, in a way, the S&P announcement could put positive pressure on Washington to address the country's budget issues.

"If we can get any positive response out of Washington, that will be good," the trader said. "There are people who like to play political games, and we're telling them this is not a game. It's real."

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