Agency spreads ease out amid fears of contagion in Europe; callable market remains robust

By Kenneth Lim

Boston, July 11 - Agency spreads widened Monday as Treasuries continued to rally amid renewed fears of spillover effects from Greece's debt crisis.

Bullet spreads underperformed Treasuries slightly on the day, although trading volumes were extremely thin.

"Spreads are wider in agencies," said Joseph J. Riley, senior managing director of institutional sales and trading at Mesirow Financial, noting it was a "very, very quiet day, and all eyes are on Europe."

The callable market has been more active, with recent redemptions helping to fuel reinvestment activity. Step-up structures also continue to do a brisk business.

"Every callable that has been brought in the last three years has been called," Riley said. "I don't think there are a lot of new outright issues, just a lot of replacement issues."

The volatility in the market has not diminished demand for callable paper, if only because the other alternatives do not look as appealing.

"They've got to put their money someplace," Riley said.

Yields keep falling

Yield levels declined again on Monday as Italy became the latest European country to come under the spotlight for its formidable debt burden.

Comments by Italian prime minister Silvio Berlusconi sparked speculation that Italian finance minister Giulio Tremonti may be struggling to keep his job. The speculation raised concerns that recent debt problems in Greece and Portugal could spill over into Italy and Spain.

"It amazes me how quickly this is spreading and nobody's talking about it urgently [in Europe]," Riley said. "They certainly don't seem to have a handle on it."

Fears about a contagion effect in Europe translated into a flight toward U.S. dollar-denominated safe-haven assets.

"It's strictly a flight to quality trade," Riley said. "As we've run up, agencies have lagged a point or two in the five-year sector."

The flight to quality also got a little bit of support from the weak non-farm payrolls and unemployment rate report on Friday, although the jury is still out on the state of the economy.

"I think most people believe the soft path theory, and that we will start to see better numbers as we go through the calendar a little further, but everybody's got it in their minds that the economy's not going to take off," Riley said.

Volumes struggle

The uncertainties in the market and the usual summer slowdown are taking a toll on trading volumes, Riley added.

"We sit and watch," he said. "Days are very long and with not a lot of activity."

The week ahead will see supply coming from the Treasury Department, which will sell $66 billion of three-, 10- and 30-year debt Tuesday through Thursday.

On Wednesday, Fannie Mae will give an announcement on Benchmark Notes issuance.

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