Agencies retake lost territory from swaps on bipartisan deficit plan; FHLB notes on tap

By Kenneth Lim

Boston, July 19 - Agency spreads pulled back dramatically versus swaps on Tuesday as a bipartisan deficit-reduction proposal eased fears of a U.S. default.

Federal Home Loan Banks found strong demand for an offering of two-year Global Notes, although the deal led to some weakness at the front end of the yield curve.

Bullet spreads were flat against Treasuries on Tuesday but came in sharply against swaps on hopes of a breakthrough in the deficit talks in Washington.

"After tremendous steepening over the last week versus the asset swap curve, the agency curve flattened significantly today," a trader said.

Trading volumes picked up as investors reversed Monday's nervous dumping.

Market gains confidence

A bipartisan group of senators on Tuesday revealed a proposal to cut the U.S. budget deficit by $3.7 trillion over the next decade, raising hopes that it would help Congress get through a deadlock over raising the country's debt ceiling by Aug. 2.

The proposal has received positive response from the White House and from some senators, although it remains unclear whether the plan would gain enough support, especially among the Republicans in the House of Representatives who are opposed to any tax increases.

The proposal was nevertheless the most visible progress in weeks in terms of a solution to the debt ceiling debate. The Treasury Department has said that the United States could default on its obligations if the ceiling is not raised by Aug. 2, while credit rating agencies have warned that they could downgrade the country's rating if a default occurs.

Treasuries and agencies, which had widened versus swaps on Monday amid concerns about the debt ceiling, recovered lost ground quickly on Tuesday.

The agency curve steepened by about 16 bps over the past week versus swaps, and on Tuesday alone narrowed by about 8 bps, the trader said. Most of the move came at the longer end of the yield curve, which will be most affected by any changes in the U.S. deficit and credit rating.

The yield curve also flattened, especially in the 10- to 30-year region.

"The long bond rallied 8 bps versus the 10-year note today, and that was like a two-week move in a couple of hours," the trader said. "They had cheapened along with the long bond, and as we got good deficit news on the deal in Washington, they came back in. That will bode well for when there is a deal."

FHLB finds good demand

The two-year sector, however, underperformed on the day following FHLB's announcement of a two-year offering.

The $3 billion offering of new two-year Global Notes was talked at a spread of 21 bps over Treasuries for Wednesday pricing. Price talk was a concession of about 1 bp to surrounding issues, market sources said.

BNP Paribas Securities Corp., Citigroup Global Markets Inc. and Credit Suisse Securities (USA) LLC are the lead managers.

"It's oversubscribed," the trader said. "It's priced right, and it may tighten before the break."

The trader said the deal "potentially put a bit of softening emphasis on the two-year bucket," but expected the deal to go well.

FHLB does not have huge funding needs, and the deal was probably aimed at keeping a liquid two-year Global issue in the market rather than raising capital. Because of that, the deal is unlikely to be upsized even if investor demand is strong, the trader said.

"I think the deal will be limited to $3 billion," the trader said. "They don't necessarily need more funding than that."

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