Emerging market spreads tighten on weak Treasuries; oil-fuelled gains may be over

By Reshmi Basu and Paul A. Harris

New York, May 19 - Spreads on emerging market debt tightened Wednesday as U.S. Treasuries declined - and prices appeared to have stabilized for the meantime.

The JP Morgan EMBI Index narrowed by three basis points during late afternoon trading.

"This is all reflection of the Treasury market, which is a little weaker today," said a trader.

Treasuries declined on profit-taking and interest rate uneasiness after Richmond Fed President J. Alfred Broaddus signaled that inflation was a concern for the Federal Reserve in a speech on Tuesday.

But emerging market bond prices have normalized since Monday, according to the trader.

"They have been less volatile than what we have experienced over the past couple of weeks, until this week."

"The bid-offer is narrowing instead of gapping out," added the trader.

Meanwhile, a capital markets sell-side source agreed with recent comment from other market participants, saying hedge funds and the carry trade have been the main driving force in activity over the past two weeks.

"The floor rate was very low - less than 4%. So you leverage yourself up to your eyebrows, and buy a bunch of high yield and emerging market debt, such as the Brazilian 13% of 2013," said the sell-side source.

"So you're short Treasuries and long speculative credits.

"But as the cost of borrowing capital increases you have to cover yours short positions.

"The more covering that takes place, the more it drives down high yield and emerging markets bonds," added the sell-side source.

No visible trends in EM

However the unwinding of carry trade positions appears to have eased.

Over the last couple of sessions, emerging market bonds have continued to drift upward with no overwhelming trend at this point, according to Enrique Alvarez, Latin American debt strategist for IDEAglobal, a research firm.

"We're seeing a broad mix of sensations out there," said Alvarez.

"After the heavy bearish move that we saw over the last few weeks we had a significant recovery.

Obviously it does not mean we've established a bull phase or anything like that. It just seems that the market was deeply oversold and we've come back somewhat.

"I think that investors are a little more confident, but overall the cautious tone is still the norm in the market," added Alvarez.

Furthermore bargain hunters and short covering have given a lift to an oversold market.

"I think you've definitely seen dedicated money come into the market over the last four of five active days," said Alvarez.

"It's been a mixture of everything. There were a lot of shorts in the market to start with and those had to cover initially. And then you obviously had bargain hunters and dedicated money return to the market," added Alvarez.

But in the near term, the emerging market bloodshed may be over given Treasury levels, according to IDEAglobal's Alvarez.

However, the market will not see an upswing given that a host of uncertainties are looming. For instance, inflation in the United States appears to have come out of hibernation.

"If you look at the U.S. Treasury market, [as long as] the 10-year doesn't pull upside of the 4.80%-4.90% yield range I don't think you're bound to see lower levels in Latin America," said Alvarez.

"It looks like we've seen the lows in emerging markets for the meantime."

"I think the market is likely to pause, probably establish a sideways trading range until you see the next batch of U.S. numbers.

"And I think there's going to be more consideration for inflation numbers than anything because I think the employment numbers are pretty much resolved," added Alvarez.

But while the selling hemorrhage has eased up in the past few days, it may be premature to assume that the market has found a new range.

"It's too soon to tell because you still have Treasury vulnerabilities and more economic data going forward," said the trader.

"But we haven't seen any of the forced selling that we had seen over the past two weeks and especially last week.

"It looks like a lot of portfolio managers just rearranged their portfolios over the past week," added the trader.

Oil producers seen over-valued

The record high price of crude oil has helped oil-producing countries outperform relative to other countries in the emerging markets asset class. But the bid on that paper may come to an end if oil prices stabilize, pushing domestic politics into the spotlight.

"Venezuela's paper has been grinding higher from its lows, but not substantially," said the trader. "Maybe it was overdone, as in the example of the Venezuela 2027 bonds."

The Venezuela bond due 2027 was trading at 82.80 at late afternoon Wednesday, off its recent high of 85 or 85.25 but still better than approximately 76 on May 10, said the trader.

"But you have to consider not only whether these bonds are appropriately priced with respect to the price of oil but also with respect to the local economy, which is still kind of a disaster.

"The only thing that is staving off a complete economic collapse in that country is the price of oil," added the trader.

According to Alvarez, the rally for the oil-producing countries may be coming to an end unless oil prices reach new highs.

"We pretty much rallied already on the $41.50 per barrel WTI story. I think going forward it's going to be sort of ebb and flow.

"If we're steady at these levels, probably some of the domestic concerns will move to the forefront," he said

In particular, domestic issues will impact countries like Ecuador and Venezuela.

"They are pretty much discounted at $41.50 for the meantime.

"Higher prices in oil - obviously, the correlation will be very strong, you'll see higher debt prices for Ecuador, Venezuela and Mexico," Alvarez told Prospect News.

Brazil sell-off easing

The violent sell-off of Brazilian debt also has eased up as investors re-evaluate their positions

"It got overdone on the downside," said the trader.

"Now everybody seems to be working out what the proper spread level is for this asset class."

In late afternoon trading Wednesday, the benchmark C bond was down 0.50 at 883/4.

The Brazil component of the EMBI tightened by 15 basis points on the session to 697 over basis points.

Increased criticism by locals over the government's austere economic policy has had little impact on bond prices, according to the trader.

"That's nothing new. [President Luis Inacio Lula da Silva's] poll ratings have been taking a dive since the second half of last year. And yet the C bonds at that time touched an all-time high," said the trader.

"At this point it may lean on the market a little. But it's nothing new."

In other news, the Brazil's Central Bank held its leading Selic interest rate unchanged at 16% on Wednesday.

Citigroup suggests overweighting cash

In a report Wednesday, Citigroup suggesting emerging market portfolio managers overweight cash and low-beta credits in the sector. The firm also favored Venezuela.

"Emerging markets have cheapened versus corporates on an absolute basis but not on a volatility-adjusted basis," according to the report by analyst Arvind Rajan and others.

"High-beta credits and those with large financing needs suffered most."

Emerging markets fell 5.57% in April and spreads have widened 75 basis points to 416 basis points since April 16, roughly equivalent to the move in high-yield corporates, the report noted. With Treasury yields stabilizing, the sector rallied 25 basis points last week, according to Ranjan.

There has been a substantial outflow of funds from emerging markets and that pace is quickening, according to the report.

Citigroup suggests overweighting cash and low-beta emerging markets credits.

"Countries with high financing needs (e.g. Brazil, Turkey, Philippines) could be vulnerable. We remain overweight Venezuela on its positive fundamentals and improving political situation."

NACF starts roadshow

In primary activity Wednesday, Korea's NACF kicked off the roadshow for its $350 million 10-year notes in Hong Kong.

The roadshow will move to Singapore on Thursday and London on Friday.

Credit Suisse First Boston and HSBC Bank are running the Regulation S deal for Korea's largest banking network.

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