Emerging market debt stabilizes as Treasuries rally; fund inflows at $126 million

By Reshmi Basu and Paul A. Harris

New York, March 17 - Emerging market debt stabilized Thursday as U.S. Treasuries gained ground, but market nervousness continued.

Treasuries ended higher on multiple factors such as economic data, higher crude prices and follow-through from General Motor's profit warning on Wednesday.

A surprisingly soft monthly manufacturing survey from the Philadelphia Reserve Bank helped Treasuries consolidate at lower yields. Manufacturing in the Philadelphia area expanded at a slower rate than expected. The index dropped to 11.4, the lowest level since March.

Also lending support, the market interpreted an afternoon crude oil spike as likely to slow the economy rather than prompting inflationary pressure.

Crude oil prices reached an intra-day record high of $57.60, before falling to $56.40 per barrel.

The yield on the 10-year note stood at 4.47% from Wednesday's close of 4.51%.

GM woes turn into EM woes

Nonetheless, the rally in the Treasury market does not bode well for emerging markets as investors are shifting funds from equities, corporate bonds and emerging markets to U.S. government bonds.

"The market has been following the jitters in the Treasury market," said a sellside source.

"But obviously in the last 24 to 36 hours, the market has had a flight to quality as people panicked over GM. So the fact that Treasuries are rallying isn't necessarily good for our [EM] markets. Treasuries are rallying because people are panicking about the credit market that is selling GM and everything else and buying Treasuries," remarked the source.

It was not that long ago that emerging market debt was enjoying record low spreads. On March 8, the spread on the EMBI+ was 330 basis points over Treasuries. Thursday afternoon, the spread on the EMBI+ was 364 basis points.

"Let's face it. Emerging markets was at its tightest levels ever a week ago on spreads. It was priced for perfection," said the sellside source.

"The one thing that everyone worries about in the U.S. has been first and foremost, the U.S. Treasury market.

"Treasuries haven't been any worse this week than last week. They were probably at their worst level last week, but I think people are more focused on the likelihood that rates are going to be higher than they previously estimated."

The major credit event ignited by General Motor's earnings warning adds more nervousness in an environment of impending higher interest rates. GM's financial woes are nothing new, noted the sellside source.

"The idea of GM moving from high grade to the junk space is an important event in the credit market - if it happens."

"GM is wider today again [Thursday] versus yesterday [Wednesday] by another 20 to 30 basis points. That's not as big as a move as yesterday [Wednesday]. But combined in the two days, it's a very huge move."

Some EM names manage gains

With 10-year Treasury notes trading at lower levels, emerging market debt saw some upward price action Thursday as the Brazilian bond due 2040 broke its seven-day losing streak. The issue gained 0.85 to 113.10 bid. At one point in the session, it was up nearly two points.

"The Brazil '40s has been as down as low as 111½ today [Thursday]. Right now they are at 113, having been at 118.90 last week for a high on the bid side," remarked the sellside source.

The Brazil C-bond lost a quarter of a point to 100¼ bid.

The "C's, because they are near the call price, tend to be weird," noted the sellside source.

The Mexico bond due 2009 slid 0.05 to 118.65 bid. The Russia bond due 2030 was up 3/8 of a point to 103 3/8 bid.

Oil exporters such as Ecuador and Venezuela were also up. The Ecuador bond due 2030 gained 1½ points to 93¼ bid. The Venezuela bond due 2027 was up 1¼ points to 101.80 bid.

The spread on the EMBI Global Diversified index tightened by two basis points to 371 basis points. The index saw a positive return of 0.40%.

Fund inflows at $126 million

While the tone in the market appears bearish, flows have been bullish. Emerging market bond funds had inflows of $126 million in the week ending March 16, according to EmergingPortfolio.com Fund Research.

This year has seen 11 straight weeks of inflows in which a total of $2.72 billion has entered the market. Last week, emerging markets took in $497.7 million, the largest weekly inflow reported since EmergingPortfolio began tracking fund flows on a weekly basis in 2001.

Global bond funds had inflows of $436 million in the week. These funds have had $4.47 billion of inflows year-to-date.

Play defensive, says research head

Investors should take on a defensive position under the current market nervousness, meaning that they play the laggards of the year, such as Venezuela and Colombia, according to Alberto Bernal, head of Latin America research for IDEAglobal.

"Naturally, we also recommend being steadfast in complying with the established stop limits, because valuations are very vulnerable."

The fundamental premise remains the same," said Bernal.

"As long as we don't see unequivocal information regarding the fact that we have seen an acceleration in economic growth in the U.S., we should still have good inflows and good interest from investors to remain invested in the Latam region, despite the very high prices," he added.

"We are simply not that bullish on the pace of US growth, among other things because we cannot see how the economy can live much longer with a 6% of GDP current account deficit."

Latin American credits have been pressured from the recent volatility in the Treasury market as the yield on the 10-year notes hit 4.50% from 4.10%.

"The market seems convinced at this point in time that we are not going back towards [a stable trading range] or very low levels - meaning below 4%," remarked Bernal.

"Under that scenario, you should see some correction in the Latam region because we are hostage to whatever the U.S. Treasury market does."

"We still believe that the investment story for 2005 remains mostly logical on a local market scenario," Bernal commented.

This year will continue to see supportive factors for Latin American credits, such as further dollar weakness and high commodity prices.

Bernal further commented that global economic growth would be respectable at around 4%. When one adds all those factors, Bernal concludes that the best alternative for the investment community is to continue to look for opportunities in the local markets.

Even with central bank intervention, currencies in Latin America are unlikely to depreciate much, he said.

"One of the reasons why they are not going to devalue much has to do with the dollar remaining weak," he noted.

"Under the scenario of high commodity prices, countries are going to have good fiscal positions this year, so that should help ameliorate some of the concerns that come up of the ability and willingness of these countries to pay their debt."

Bernal recommends that investors go short on the long end of the curve and long on the middle part of the curve because he expects additional steepening due to the Treasury instability.

"Under the current scenario of very high volatility, taking directional exposure at a given point of the curve without trying to ameliorate the risk on other sectors of the curve is dangerous.

"We have been recommending to investors some defensive trades.

"That's the best way to play uncertainty at this point in time. But we stop short of recommending to some investors outright shorting the market or outright longing the market because you can get burned very easily with this volatility," he concluded.

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