Agencies tighten as court ruling eases concerns about Europe aid; FHLB reopens two-years

By Kenneth Lim

Boston, Sept. 7 - Agency spreads narrowed on Wednesday as bailout plans for Europe's troubled economies survived legal challenges in Germany.

The two-year sector was nevertheless softer on the back of supply from Federal Home Loan Banks, which reopened an existing series of Global Notes at the front end of the yield curve.

Bullet spreads widened by about 1 basis point to 1.5 bps in the two-year sector but narrowed versus Treasuries in other maturities. The five-year sector closed the day about 1 bp to 2 bps tighter to Treasuries, "for the most part a bit of a reversal from yesterday," an agency trader said.

"The stock market is what's ultimately driving us right now, and that's taking the cue from Europe," the trader said.

Callables remained in strong demand despite callable spreads versus bullets tightening over the past several sessions.

"In general there have been quite a bit of retail-type deals," the trader said. "Funding richened in the last day or two for the issuers, so some of the longer openings are being reflected in terms of lower coupons. But they're still standing on extremely good demand given all the redemptions."

Despite the tighter callable spreads, investors remained hungry for callables because they were more interested in the higher yields that callables offered over bullets and Treasuries.

"They're not trading callable spreads, they're buying yields," the trader said.

Nevertheless, some investors were looking out on the curve for even better returns.

"People buying three- to five-year callables are now buying three- to five-year steps, or fixed to floaters, or more esoteric structures to pick up incremental yields," the trader said.

Court ruling eases fears

The flight to quality trade that marked Tuesday's widening reversed course on Wednesday as the winds that drove the flight also shifted.

After reports over the weekend raised doubts about Europe's ability to address its debt crisis, investors' fears were soothed Wednesday after the German constitutional court ruled that Germany-supported bailout plans for some of the debt-laden peripheral economies in Europe are legal, but future bailouts agreements will need approval from the parliament.

"We walked in yesterday after the long weekend to wider swaps spreads and lower stock prices, so there was a natural upward pressure on swap spreads and agencies just kind of followed suit," the trader said. "It also felt like there was a bit of waiting and watching yesterday."

The German court's decision cleared a cloud that was hanging over the European debt crisis and freed up a risk-off trade Wednesday that narrowed spreads and lifted the equity markets.

Europe and equities will probably have a strong effect on prices and yields in the days ahead, as will speculation about what the Federal Reserve will do after its policy meeting on Sept. 21.

"Right now it feels good; stocks are up and Treasuries are a little bit softer," the trader said. "But we're still bantering about what the Fed may or may not do at its meeting in two weeks, and that's driving the curve.

"It's kind of setting up for a bit of a choppy trade, and agencies are just kind of going with the flow," the trader added. "Spreads are not really going to move too strongly one way or the other."

FHLB reopens two-years

FHLB on Wednesday sold $1.25 billion of its 0.5% Global Notes due 2013 to yield 0.343% in a reopening auction.

The notes were sold at 100.308319. There were 2.3 times as many bids as notes offered, according to a press release.

The outstanding amount of notes in the series now stands at $4.25 billion.

The deal priced at a spread of about 13.9 bps over Treasuries. By the end of the day, the spread on the notes had widened slightly to about 14.5 bps bid, 14 bps offered.

Investors were not surprised by the announcement of a deal.

"I think from a funding and maturity standpoint, either a two- or three-year was probably the best bet," the trader said. "I thought a three-year was a better fit, but obviously they were already funded which meant a two-year."

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