Agencies widen as economic worries, breaking of technical resistance spur Treasury demand

By Kenneth Lim

Boston, Aug. 4 - Agency spreads widened sharply Thursday as economic concerns and felled technical barriers released a flood of Treasury buying.

Bullet spreads closed out by 2 basis points to 4 bps across the board, with five- and 10-year issues performing worse than shorter maturities. Five-year Freddie Macs were trading at spreads of about 35.5 bps bid, 34.5 bps offered at the end of the day, wider by about 3 bps.

"For the most part everything got whacked pretty good, especially at the end of the day," an agency trader said. "It was a combination of things, with the last laydown in stocks pushing wider in swaps. Until this morning it was actually better buying, then something just seemed to turn on the spigots."

Trading flows were nevertheless balanced, with sellers easily finding buyers, the trader said.

The callable market actually saw decent activity with new paper that had already been negotiated coming to market.

"When rates drop precipitously, previously negotiated paper drops along, and you get a little bit better value," the trader said. "Having said that, some of the auction paper from [Federal Home Loan Banks] and [Federal Farm Credit Banks] that have come out over the past few days look relatively cheap to where the new deals are."

If rates are expected to stay low, issuers will also continue to redeem existing issues, putting more money back in the hands of investors and possibly fueling reinvestment demand for new issues, the trader added.

Yields collapse

Yields fell across the board Thursday as fears of a double-dip recession sparked selling in equities and buying in Treasuries.

Critically, the buying was strong enough to push the 10-year Treasury yield toward the previous technical resistance level of around 2.58%. Once it became clear that the barrier would not hold up, investors were quick to pour into Treasuries, giving the day's rally another boost.

"There are a lot of guys who were caught off guard or surprised by the move," the trader said. "I don't think anybody expected it. It really started with a technical move, and then really just snowballed. It was one of those cases where people got run over.

"Just a week or two ago we were talking about hitting 3.25% on 10s, and now we're at 2.40%. It's unbelievable."

Buying was especially furious at the front end of the yield curve, especially after Bank of New York Mellon Corp. said in a surprise move that it would charge a fee on custodial accounts that have deposits with the bank. The announcement led many money-market managers to take money out from their deposits to buy bills instead of paying the fee. Treasury bill yields dipped into negative territory on Thursday.

Payrolls, QE3 in focus

Thursday's sell-off was sparked by a myriad factors, including overnight pressure on European markets amid worries about the region's debt crisis and the global economy.

U.S. investors were also worried about the domestic economy after a string of disappointing data.

"All signs point back to the [gross domestic product] print that was the catalyst," the trader said. "After they revised earlier growth, it suggested that we're getting no recovery, which suggests no turnaround in jobs, which suggests no spending. It's just really an emotional thing right now."

The market is now looking to Friday's labor situation report for the next piece of the puzzle, even though the events of Thursday made it hard for investors to set up for the data.

"The way today went, I don't think people even had a chance to prepare for payrolls," the trader said. "If tomorrow we get an up 200,000 print [in non-farm payrolls], that would prompt a fairly decent move back in the other direction. If it comes to the 75,000 range, that will just affirm what people already believe."

The market is also speculating about the possibility of a third round of quantitative easing after the Federal Reserve meets after the weekend. But a number of market sources said they did not expect the Fed to begin another round of easing, but to shift its portfolio toward longer maturities instead.

Agency spreads will continue to play catch-up with Treasuries for the most part.

"Until we get to the point where we're capturing a flight-to-quality move, I'd venture to say we're purely dependent on the direction of Treasuries," the trader said. "If we get any kind of sell-off tomorrow, we'll be tighter. If we go any lower in Treasury yields, agencies will lag."

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