Emerging market debt slides for second day; market continues adverse reaction to Fed minutes

By Reshmi Basu and Paul A. Harris

New York, Jan. 5 - Emerging market debt was trounced for the second straight day Wednesday, as negative sentiment invaded the asset class.

Emerging market debt was expected to have strong start to the new year but instead the market is falling hard on inflation worries.

Tuesday's emerging was dampened by a derailment in the U.S Treasuries market, where yields rose in reaction to the hawkish minutes from the Dec. 15 meeting of the Federal Open Market Committee.

And the emerging markets slide continued into Wednesday's trading session.

Debt is "down a lot today [Wednesday],"said a trader.

"The Brazilian 2040 is down about a point" closing at 114¼ bid, 114½ offered.

"In general, the entire market is down. It's not even Treasuries anymore. It just seems that EM in general is overpriced a bit. A lot of sellers out in the new year," he remarked.

He added that banks, locals and large New York institutions played in Wednesday's session.

As the trading day progressed, prices fell after an early morning uptick, according to the trader.

"It's been pretty heavy volume in the past two afternoons," said the trader. "Once the trading starts, everyone is piling along and going in that direction. It was up this morning but then down again this afternoon. It did the same yesterday [Tuesday]," he commented.

In late morning trading, the Brazil C bond was bid at 101.062, down 0.438. By mid-afternoon, the bond had fallen three quarters of a point. The bond closed down 0.938 at 100.562 bid.

The Russia bond due 2030 was also weaker. In late morning, the bond was bid at 101 5/8, down 1 1/8. By mid-afternoon, the bond lost 1.30 points. At the end of the session, the bond was down 1.32 to 101.43 bid.

Paper from Mexico, Turkey and Venezuela were also down. The Mexico bond due 2009 slid 0.30 to 121 bid. The Turkey bond due 2030 lost three points to 141½ bid. And the Venezuela bond due 2027 dropped 1½ points to 102.15 bid.

Moving ahead, the tone of the market will be set by the upcoming release of U.S. non-farm payroll numbers.

"It's going to trade a lot up until then. But Friday's numbers will tell which way the market is going to go in the next month or so," said the trader.

Reading the Fed minutes

At face value, the minutes from the FOMC meeting said that interest rates are not where they need to be and that rates will rise, said a sellside source.

"But the whole market expects that," the source observed.

The source noted that Tuesday's weakness in the Treasury market was not that big, given that the yield of the 10-year note stood at 4.33% last week.

Nonetheless, Tuesday and Wednesday's market slide may be a foreshadowing of things to come for emerging markets debt, as the asset class becomes riskier in an inevitable environment of higher interest rates, according to an emerging market analyst.

"I don't think yesterday's [Tuesday's] trading action was just a knee-jerk reaction to the Fed, I think it was a rational response to the higher probability of tighter liquidity conditions.

"As the Fed gets closer to having to move away from its 'measured' pace of rate hikes, the market has to get worried about risky assets like EM.

"The market will probably wait for another shoe to drop in the outlook for U.S rates until the sell-off resumes speed, but I think the trend is still going to be for higher rates," he added.

However, the sellside source believes the market overreacted.

"And I think it shows that our market is very skittish in terms of valuations. People went into year-end recognizing that valuations were high, and that supply in January could be a risk."

Local currency plays seen raising risks

Meanwhile, investors are turning their attention to local markets, expecting them to outperform, according to the sellside source.

"They're buying local currency-denominated government debt," the source said. "That seems to be how they are positioning themselves to handle a generally unfriendly rates environment in 2005.

"Those trades are now said to be very crowded, with a lot of people in them who maybe don't have a lot of experience in those markets."

Investors find these deals attractive because "they feel they are getting a big pick-up in yield, one that compensates them more for the risk they're taking, although they will probably be prone to run at the first sign of potential problems," remarked the sellside source.

"I think that is something that increases the vulnerability of our market a lot - not just the local component, but the broader market."

Active trading in Asia

Asian paper saw heavy flows in Wednesday's trading session in Asia, according to a market source.

Amid recovery efforts underway for the victims of the Dec. 26 tsunami, the Republic of Indonesia is expected to offer up to $1 billion of global bonds by the end of the first quarter of 2005.

Indonesian paper has remained unhurt by the tragedy.

In trading Wednesday, the Indonesia bond due 2015 was at 101.25 bid by the end of Asian market hours, unchanged from Tuesday's close.

Meanwhile, Korea's bond due 2005 tightened one basis point to 52 basis points over two-year Treasuries.

The Export-Import Bank of Korea bond due 2014 was unchanged at Treasuries plus 80 basis points.

The long-end Philippines' bonds fared well on a better-than-expected Moody's opinion. The bond due 2008 was bid at 108.25 from Tuesday's 108 bid.

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