Emerging market debt holds steady after Fed pause; spreads unchanged on day

By Reshmi Basu and Paul A. Harris

New York, Aug. 8 - Emerging market debt traded flat throughout the session Tuesday, unmoved before the Federal Open Market Committee meeting and similarly unchanged in response to the central bank's decision to leave the fed funds target rate unchanged at 5.25%.

Prior to the FOMC's decision, which ended a sequence of 17 consecutive rate hikes, emerging market investors stayed on the sidelines.

A pause was somewhat a sure thing, noted a market source. Instead the market was more concerned with the comments accompanying the Federal Reserve's decision.

In the statement, the Fed gave itself some maneuvering room, leaving the door open for more rate hikes. By the end of the session, U.S. financial markets did not approve.

"Inflation pressures seem likely to moderate over time," the Fed said, "reflecting contained inflation expectations and the cumulative effects of monetary policy actions and other factors restraining aggregate demand."

Furthermore adding to market consternation, there was one dissenter among the voting members. Reserve Bank of Richmond president Jeffrey Lacker opposed the decision but there was no explanation as to why.

"What the Fed did was as much in line with expectations as you could have possibly have gotten," remarked a sellside source, who added that the statement could be interpreted as slightly disappointing because the statement suggests a temporary pause instead of an end to the tightening campaign.

"People are saying that the Fed might be cutting rates by the end of the year, but I think that's still a hard call to make."

U.S. stocks down, EM unmoved

Immediately after the release of the Fed's decision at 2:15 p.m. ET, stocks shot up but that rally was short-lived on the back of worries that the Fed would resume tightening at its subsequent meetings. The Dow Jones Industrial Average closed down 45.79 points. Meanwhile U.S. Treasuries were unchanged.

As stocks erased gains, emerging market debt finished the session flat, unable to squeeze any more juice out of the Fed's decision.

In the last couple of weeks, emerging market debt has rallied on the expectation of a pause. On Monday, spreads tightened by three basis points despite lower U.S. Treasuries and equities, following Friday's rally on the back of weaker-than-expected non-farm payroll numbers.

With equities edging lower, there was no catalyst to move emerging market debt higher, according to Enrique Alvarez, Latin American debt strategist for think tank IDEAglobal.

Furthermore, he noted that the Fed might have backed itself into the corner depending on how U.S. economic data stacks up.

In the short to medium term, the market now becomes more sensitive to U.S. inflation data heading into subsequent FOMC meetings. If that data shows a higher-than expected run up in inflationary pressure, then the Fed will likely raise rates at its September meeting.

"I don't think that's really positive for the market. And more importantly, I think it puts a lot of pressure on the U.S. side because there's a credibility issue built in there," Alvarez added.

However, if one takes the Fed's statement at face values - i.e. a deceleration in U.S. growth will put a lid on inflation - then the overall scenario for Latin America is positive over a longer period of a time, Alvarez explained.

In the near-term, it is easier to build a constructive scenario based on the pause. But the medium to longer term picture is laced with uncertainty as inflationary looks to pick up.

For the day, emerging market debt was unchanged. During the session, the bellwether Brazilian bond due 2040 gained 0.25 to 129.35 bid, 129.45 offered. The Argentinean discount bond due 2033 added 0.65 to 96.80 bid, 97.15 offered. And the Venezuelan bond due 2027 moved up 0.35 to 124.86 bid, 124.95 offered.

Elsewhere, the Russian bond due 2030 lost 0.13 to 109.75 bid, 110 offered. And the Turkish bond due 2030 also gave up 0.13 to 148 bid, 148.50 offered.

Issuers lined up in September

On the primary front, the sellside source noted that there are issuers lined up for September. But there is no one out there so desperate that they need to do anything at the moment.

"We're trying to talk one or two corporate issuers into the market. You have Brazil 2015s trading at all-time tights. How much better does it get?

"We have issuers on the sidelines either thinking that it will get better, or that they don't need to do it right now because they have cash on the balance sheet," noted the source.

From a sellside point of view, it is much easier to imagine it getting worse than getting better. After all, it is hard to argue that spreads can improve much more.

For instance, Brazil is trading inside of where the Mexican 10-year bonds were trading during the May/June sell-off. Additionally, there has been good demand for recent corporate deals, such as Pan American Energy and Friboi.

Investors are definitely looking for paper right now, specifically in the form of corporate paper because it offers a pick up over the sovereigns.

"I think corporate activity is going to dominate emerging markets during the last four months of the year because a lot of sovereigns have not only finished 2006 but have gotten a good start in pre-funding 2007," said the sellside source.

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