Inflation fears end short-lived emerging market rally; Ecuador thrashed on political turmoil

By Reshmi Basu and Paul A. Harris

New York, April 20 - Emerging market debt staged a short-lived morning rally Wednesday before succumbing to inflation concerns, while Ecuador's paper was left in shambles from the ousting of the country's president.

Even though emerging markets rallied in the early morning, Ecuador's bonds were the exception as protests against president Lucio Gutierrez intensified over the dismissal of the country's Supreme Court and his alliance with factions to clear ex-president Abdala Bucaram of corruption charges.

By late afternoon, the rumors of his departure had become reality as 60 opposition congressmen out of the 100-member chamber voted to sack Gutierrez.

Ecuador paper "crushed"

By the close of the session, Ecuador emerged as the big loser of the day. Its bond due 2030 fell 3¼ points to 96¼ bid while the bond due 2012 plunged 4¼ points to 96¼ bid.

"Obviously, the prices have gotten crushed," said Enrique Alvarez, Latin America debt strategist for IDEAglobal.

"It started yesterday [Tuesday] but it has taken on a huge hit today [Wednesday]. Gutierrez is obviously on his way out but it is not because congress has voted him out," he said.

Alvarez told Prospect News that Ecuador had a parallel congress, which said that the legislative body does not want to consider any new measures on the Supreme Court, so the opposition formed their own congress, which then voted Gutierrez out.

Opposition congressmen said Gutierrez had "abandoned his post" by failing to properly carry out presidential duties.

A buyside source said the sacking of Gutierrez came as no surprise.

"The political situation in Ecuador has been very fluid," she said. "Congress is very fragmented. President Gutierrez's popularity was very low.

"So I think while it is a pretty violent outcome, a lot of people had predicted that he would not be able to finish his term in office, remarked the buyside source.

Vice president Palacios sworn in

Alfredo Palacios was sworn in by the opposition congress to replace Gutierrez. According to a source, the only constitutional provision for succession is for the vice president to take over as president for the remainder of the current term.

Gutierrez's term would have run through January 2007, with first and second round elections taking place in October and November of next year.

"The people of Ecuador, particularly the people of Quito, today have ended the dictatorship, the immorality, the great power, the terror of fear," Palacios told the Congress upon being sworn in.

Alvarez added that a new president would not calm the situation, given the uncertainties that lie ahead.

"Gutierrez has already loss the support of the military. The opposition congress has voted him out, so he should be leaving.

"Nonetheless, there still may be a chance that there may be some reaction by his followers," remarked Alvarez.

Secondly, he added that Gutierrez's lifeline in government, the Roldosist Ecuadorian Party (PRE), has yet to react.

"Further on, Palacios isn't necessarily a pro-market type candidate or pro-market type politician. So that doesn't necessarily bode well for bond prices either.

"I don't the conflict is totally resolved. There are still some ends that need to be sorted out. I think you could see more chaos before things finally stabilize," remarked Alvarez.

Not wise to buy, says investor

According to an analyst note, the upheaval may serve as an opportunity to buy the country's paper at semi-distressed levels. But the analyst warned that spreads might widen further until the situation is settled. The strategy is most useful for those who can buy and sell quickly on news, said the analyst.

But the buyside source said it would not be prudent to buy Ecuador on the theory that current levels are cheap - "not at least until we get some clarity on who will be the next president."

"I think the situation is too fluid to buy on weakness."

Debt swap seen unlikely

Earlier on Monday, representatives from Ecuador said they would go ahead with a swap of its global bond due 2012. That intention may have been killed off with the noise in Ecuador, said sources. (See related story elsewhere in this issue.)

A sellside source that the swap was unlikely, given the political troubles.

"From a strategic point of view, it's not a good transaction. Even the locals are saying that," he said.

He added that banks are asking so many questions because their strategy does not seem good enough.

"I'm sure that there are banks willing to take a mandate from them. The thing is how long will that mandate last?"

EM down

The first buyside source said emerging markets generally started off with a better bid, "but then it waned off at the end of the day" due to Ecuador and weaker U.S. Treasuries.

The yield on the 10-year note was 4.21%, below an intraday high of 4.29%.

During the session, the Brazil C bond lost 1/8 of a point to 99½ bid while the bond due 2040 lost 0.60 to 112.90 bid. The Russia bond due 2030 fell 1/8 of a point to 105 1/8 bid.

The source added that she expects the downtrend to continue for the next couple of days.

"In Ecuador, there was some real money reducing positions during the afternoon," she remarked.

In the overall market, "it still is mostly hedge fund and Street driven."

IDEAglobal's Alvarez added that Ecuador did not have a contagion effect on the general market, given that the sovereign is a very high beta name.

"The amount of players that actually participate in Ecuador is very limited because it is very high risk and always has been.

"I don't think it has enough size or influence to actually exercise any contagion on the market."

He added that the story did not develop overnight and that the market could see it coming.

"Now, if you want to look at why prices turned when they were a little higher," said Alvarez, "you had some disappointments out there as far as inflation numbers in the U.S. And that creates the conundrum for emerging markets if we are under the guidance of higher inflation or slower growth," he added.

He also said that a president leaving their post does not help sentiment.

"It reminds people where we are actually dealing," he said. "It's emerging markets. It's not the U.S. triple-A corporate side. You are dealing with very high risk instruments."

CPI comes below expectations

In early morning activity, U.S. Treasuries rallied on the March consumer price index report, said the sellside source. U.S. consumer prices rose a seasonally adjusted 0.6% in March, with core prices rising 0.4%, according to the Labor Department

The number was double than what was expected, said the source. "But somehow, rates are not reacting to that. And that is the whole question that economists are having: is there going to be growth with this kind inflation or are we are going to have inflation with no growth?

"The market is not realizing that in the sense that it is not asking for higher yields."

He added that later in the year, he expects to see "very much larger widening" on emerging market spreads.

Meanwhile a second buyside source said that spreads are still tight, despite the recent sell-off.

"Spreads in the EMBI Global index went as low as 320 in March, and peaked at 407. So that wasn't that much of a correction," he said early in the session.

"Right now it's at 379. It has recovered 30 basis points from the high two days ago.

"The Global index is not constrained. A lot of people still look at the EMBI Plus Index, the spread is a little more extreme. The EMBI Plus doesn't have a lot of the new debt. It went from a low of 326 to as high as 420. Right now it sits at 390, which is 30 basis points inside of the high."

GM woes

For the past two weeks, most of the bond market volatility has been related to the corporate side, stemming from General Motors Corp.'s troubles, said the sellside source.

"If GM were to be downgraded to junk, it would be a huge supply to the junk market and that would change the allocation of portfolios.

"In the recent past, people have always looked at the U.S. corporate market as a benchmark and they see how much emerging markets are trading wide to that market. And if the U.S corporate markets widens, then somehow it will also affect EM markets," he said.

A third buyside source added that the market might have seen the peak in terms of spread widening on GM.

"It seems clear that the unions are not going to budge: they don't appear to be ready to make meaningful concessions," he said.

"And GM already said it won't cut the dividend.

"So it really comes down to what they may to on the GMAC side. They may want to sell a stake in it to isolate it from the GM operations.

"It's a developing story. And it's going to take a little time. But I don't see it widening from here," he added.

PDVSA worries

The source remarked that PDVSA, the Venezuelan national oil company, is drawing concern from market participants.

"A few days ago we heard that they may want to sell some of the less profitable Citgo units," he said.

"A few months ago President [Hugo] Chavez stated that he basically wanted to sell all of the Citgo refineries in the U.S. and that he wanted to stop selling oil to the U.S. So the market became concerned about what he really wants to do.

"But I think Venezuela does want to cash out a couple of Citgo refineries that are not profitable for them," he commented.

Primary market

The second buyside source said he expects to see more corporates tapping the market, "but less is coming on the sovereign side."

"Indonesia came as a little bit of a surprise because the size was a little more than people expected.

"But I see Russian corporates and Eastern European corporates coming."

The sellside source said that South Africa will no longer tap the market in May because it has higher revenues.

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