Agencies underperform as debt ceiling doubts prompt profit taking; heavy week for supply ahead

By Kenneth Lim

Boston, July 25 - Agency spreads widened Monday on a wave of profit taking and concern about the lack of progress on a deal to raise the U.S. debt ceiling.

Bullet spreads shifted out by about 2 basis points against Treasuries in shorter maturities, and by about 1 bp in the belly of the curve.

"Everything was getting hit today," an agency trader said.

Trading volumes were slightly muted amid uncertainty about the outlook for U.S. government-backed assets.

"Flows today were relatively light," the trader said.

Callables were also under a little bit of pressure, another market source said.

"I think it's just going to be hard this week to make any kind of big move," the source said. "There's Treasury supply coming up the next three days, Fannie Mae on Thursday, the debt ceiling coming closer and closer. A lot of uncertainty."

Default fears rise

Investors lost some confidence that U.S. lawmakers would be able to avert a default by reaching a deal on the country's budget deficit and debt ceiling, which the Treasury Department says must be raised by Aug. 2.

Negotiations on a deficit deal broke down over the weekend, with the Republican-controlled House of Representatives and the Democrat-controlled Senate pursuing separate proposals that seem set to prolong the stalemate.

"What we have is idiots playing a political game of chicken with the lives of billions," the source said.

The source said investors are hedging against a possible default by the country or a credit rating downgrade by shifting assets out of dollar-denominated sectors, such as emerging currencies.

"The only problem is there's no way to really hedge against a U.S. downgrade," the source said. "The certainty of the U.S. paying back its debt is such a fundamental foundation in global finance that it's hard to imagine anything that's not going to be affected."

The potential cost of a U.S. downgrade is one of the reasons why the market has so seemed confident that lawmakers would not let the country default on its debt, although that confidence has been wavering, the trader said.

"I think there's clearly less confidence," the trader said.

Slight profit taking

Agencies also came under pressure Monday because of relative richening over the previous week as a strong swaps market helped to buoy agencies.

"Even though swap spreads are in, agencies sold off as an extension of government debt," the trader said. "Last week was good for agencies partly because swap spreads came in on the risk on trade.

Federal Home Loan Banks' new two-year Global Notes have widened by 5 bps since pricing at a spread of 20 bps over Treasuries on July 20, the trader added. That was a rare strike in the two-year sector, which has otherwise been a resilient part of the curve.

The outlook for the week is murky, although spreads could hover around current levels if investors cannot decide which way to go, the trader said.

"I think five-year stuff are getting toward normalized levels, and the three-year is the same," the trader said. "The two-year sector is rich, but it's been trading there, so come tomorrow maybe it won't be moving much."

The week ahead will see active primary action, with the Treasury selling $99 billion of two-, five- and seven-year notes through Thursday. On Thursday, Fannie Mae could also announce an offering of Benchmark Notes.

"People seem to think there's a possibility for two-years," the trader said.

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