Agencies tighten; safe havens eyed amid drop in consumer confidence, mixed home prices

By Kenneth Lim

Boston, Aug. 30 - Agency spreads narrowed modestly Tuesday as weak consumer confidence data sparked another flight to quality.

Bullet spreads tightened slightly over the day, benefiting from a rally in Treasuries, which lowered yields and forced some investors to seek better returns out on the risk curve.

"As interest rates on Treasuries go down, more people are buying in agencies as people are searching for yields," said Mary Ann Hurley, vice president of fixed income trading at D.A. Davidson & Co.

Spreads closed the day near to recent tights, she added.

Callables remained the most active segment of the agency market.

"Definitely much more activity in callables than what there are in bullets," Hurley said. "People want the additional yields, so steps continue to be very active just because with interest rates so low, steps are considered to be very defensive structures."

Because yields are so low at the moment, some investors are accepting shorter call protections in order to lock in higher yields. On the other hand, expectations that front-end yields will remain low for the next couple of years are leading some investors to demand longer call protection.

"Some are going for longer call protection, but because interest rates are so low, it's really a variety of stuff," Hurley said.

Consumer confidence tanks

Investors bought up safe-haven assets Tuesday on the back of weak economic data, most notably the Conference Board's Consumer Confidence index.

The indicator of consumers' willingness to spend fell to 44.5 in August from the revised previous reading of 59.2. The market had been expecting an index level of around 52.5.

"The consumer confidence number this morning was very, very weak," Hurley said.

The S&P/Case-Shiller Home Price index was also seen as weak despite a 1.1% month-on-month increase in home prices. Year-on-year prices remain depressed, and the previous month's gain was revised lower to 1% from 1.1%.

"Adjusted data was a little weaker than expected," Hurley said. "Year-on-year prices are still negative, although at a less negative rate than what the previous month was."

Market response was more muted for the minutes of the Federal Open Market Committee's August meeting, in which the Federal Reserve's policymaking body said it would keep short-term rates low until mid-2013.

The FOMC considered a range of potential actions to address a weaker-than-expected economy, with more dovish members advocating even more accommodative policies, according to the minutes.

"The key takeaway for me was there were members that felt further asset purchases were needed and that Fed policy could be doing more to help the economy," Hurley said.

But Hurley did not expect the Fed to pursue a third round of quantitative easing soon.

"I think [Fed chairman Ben Bernanke] would like to for sure, but I just don't think the votes are there," she said.

Investors forced outwards

The low interest rate environment has made the front end of the bullet yield curve less attractive for many investors, who find the low returns they can get in the two- or three-year sectors not worth the trouble.

Many investors have turned to callable structures for better yields, but some have also extended toward longer maturities.

"People who traditionally were in the two- to three-year area have now probably moved out to the five-year area, so we have seen some yield-curve extension orders just because short rates are so incredibly low," Hurley said.

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