Emerging market debt mixed in trading, still searching for rates guidance

By Reshmi Basu and Paul A. Harris

New York, May 4 - Spreads for emerging market debt tightened in trading Wednesday although investors still remained unclear as to when the Federal Reserve Bank will act to raise interest rates.

"The news out today wasn't exactly the Northern Star", said a trader. We knew that the rates are on the up, but when?"

"Trading was mixed for the day," he said. "Spreads ended the day tighter - about nine basis points."

In mid-day trading, the JP Morgan EMBI index was at a spread of 492 basis points, six basis points tighter than Monday's close.

The Brazil component of the EMBI was at 675 basis points, 27 basis points tighter from the previous day's close.

Brazil's bond due 2040 finished at 91.75, up about 1.875.

While the Federal Open Market Committee decided to keep its federal funds target rate steady at 1%, the committee said that the hike would come at a "measured" pace.

The market is now focused on the last sentence, said a market source.

The last sentence said: "At this juncture, with inflation low and resource use slack, the Committee believes that policy accommodation can be removed at a pace that is likely to be measured."

"For the first time in four years, the Fed has explicitly stated that they are about to tighten policy.

"Measured pace? What else can they say? Haphazardly?" asked the market source.

The market will look for more direction when U.S. employment numbers are released this Friday.

Investors have been guessing where the bottom lies in emerging markets' recent decline. However, there are also concerns that there might not be any bargain shoppers.

"In general I think the feeling is that there is not really a lot of cash out there that is actually looking for the bottom," said a sell-side source.

Going into 2004, investors were overweight in Brazil. Sovereign deals priced very tightly. Now, the extreme is happening in the opposite direction, the source forecast.

"The Brazil 2034, the deal that they did in the beginning of the year was priced at around 375 over Treasuries. If you step back and think about that it's a ridiculously tight spread," said the sell-side source.

"Now the bond is trading at 625 over Treasuries. That may be equally ridiculous. But it's probably closer to where it should be as opposed to 375."

One worry that may rear its ugly head is what happens when issuers have to come to market.

"And it may be that the market is too worried about that," said the sell-side source. "There are very few sovereign issuers out there who need to do anything."

But Brazil and Turkey are two sovereigns that do need something.

"In a real worst case scenario, where Brazil is doing the right things from a policy standpoint but couldn't access the market because the market was so bad owing to the Fed and everything, I suspect that they would manage to find the money elsewhere - either from multilaterals or they would just draw down reserves," said the sell-side source.

"It's not the case that if they don't raise $2.5 billion they will default on their debt or anything. They have reserves. They have cash."

In general, Brazil's strategy has been to raise as much money as possible to repay its external amortization. In doing so Brazil is not increasing foreign debt but keeping it level.

"So it's not the end of the world if they can't borrow," the source said. "It's not great. Maybe they have to put more into the local market, which could push up local interest rates.

"I suspect that they are wishing they had done a little earlier on. But I think they were trying to do the right thing and be cautious," said the sell-side source.

But if Brazil is holding out for a bigger deal the environment has not been friendly to large deals of late.

"You saw that with the Peru deal, which was just too big," said the sell-side source. "If they had done a smaller deal it would have been okay. But because they pushed up the deal size it really caused the deal to tank."

Holiday gives Russia a chance to review

Meanwhile holidays in Russia for this week through May 10 may serve as an opportunity corporate issuers that recently shelved deals to observe market reactions to the Fed meeting and the upcoming payroll numbers on Friday.

"If we come out of those with more stability in the market and you have the local players in the Russian market back from the holiday, maybe Gazprom and Vimpelcom come back," said the sell-side source.

"But I don't expect any decisions like that until sometime next week at the earliest. And they would only come if they saw stable market conditions."

Asian debt outperforming

While Asian debt has been outperforming its counterparts, higher-beta Asian issues have been weak.

"But, for example, Indonesia has been pretty weak - not as weak as Brazil, but it has still been weak," said the sell-side source.

"The Philippines is probably the one place that is doing a little better. That's because you have elections coming up in a few days, which is probably interjecting some incremental news into the trading, that you don't have in the other countries."

China seen cooling, not stalling economy

Looking at China, the measures announced last week to cool the economy sent shockwaves through the markets but there is no danger of a major meltdown, according to an analyst.

The effects will be not as crushing as the Chinese government would not do anything that would unravel its political base, according to Jephraim Gundzik, president of Condor Advisers, a firm that provides emerging markets investment risk analysis to individuals and institutions.

"The government is the only source of credit in the economy because all the banks are state-controlled," explained Gundzik.

"The potential for a real credit squeeze to occur in China is zero because the government would have to force banks to tighten lending."

Taking away credit would cause an economic disaster, which would cause a social disaster, which would cause a political disaster.

"They are going to slow things down - but a catastrophic slow down, no way. Too much is at stake for them," Gundzik told Prospect News.

China is not like any other any Asian country because it does not depend on external or domestic capital markets for credit or liquidity.

"Banks are the sole source of credit and liquidity," said Gundzik.

Most other Asian countries rely on external credit and domestic capital markets. "These sources of financing can quickly dry up as occurred during the Asian liquidity crisis. A repeat of this in China is not possible," he added.

Thailand plans $1 billion

Meanwhile the Thailand government plans to issue $1 billion of three-year floating notes.

A market source told Prospect News that the government wants to sell the issue before interest rates go up.

The notes will include one year of call protection.

Proceeds would be used to pay back higher interest loans from the World Bank and Asian Development Bank.

Barclays Capital is underwriting the deal.

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