Emerging market debt unfazed by Fed action; Indonesia expected to issue new paper

By Reshmi Basu and Paul A. Harris

New York, Sept. 20 - Emerging market debt appeared unfazed Tuesday even as the Federal Reserve hinted that more rate hikes lie ahead.

In a foregone conclusion, the Federal Open Market Committee raised short-term interest rates to 3¾%, the 11th straight 25 basis points increase. Also, its statement implied that there would be no pause this year.

Some investors had been banking that the Fed would take a time-out in its current monetary tightening campaign because of the devastating effects of Hurricane Katrina.

Instead the FOMC said it would stick to its game plan of measured rate hikes since Katrina did not pose a long-term threat. The FOMC statement added that inflation was the principal concern post-Katrina.

"The widespread devastation in the Gulf region, the associated dislocation of economic activity and the boost to energy prices imply that spending, production and employment will be set back in the near term," the FOMC said.

"While these unfortunate developments have increased uncertainty about near-term economic performance, it is the committee's view that they do not pose a more persistent threat," the statement said.

EM shows no reaction

In reaction, short-term U.S. Treasury yields tanked. The yield on the two-year note jumped up 6 basis points to 3.98%. But the 10-year Treasury note stood unchanged.

And emerging markets held its ground, showing little reaction to the Fed's decision, said sources.

"It's a surprise to all markets that the Fed has been so dismissive of Katrina effects, and EM is no different," said an emerging market analyst.

"The way markets are reacting, though, the bulk of the damage is being felt at the short end of the Treasury curve and in equities.

"EM is traditionally dependent on both these markets - on the short end of the curve because of its liquidity impact, and on the equities market because of what it says about the health of the global economy and what that can mean for commodities prices and EM exports.

"So far EM hasn't really moved on the Fed news, tracking along with 10Y USTs," he added.

A buyside source said that the inaction by emerging markets was not an outright shocker, since the market has shown little reaction to past Fed hikes.

"Treasuries sold off and then they rallied real aggressively and then they sold off. Thirty-year is up and 10-year is flat. I don't think the EMBI spread moved," he said.

"We've been raising rates for over a year and it [EM] keeps tightening in the face of that. It's surprising but it seems the way things are going to go."

The source did note his astonishment at the ability of the market to grind tighter.

"Spreads are so freaking tight. I don't know how it's keeping it up right now," he remarked.

But at some point the market will have to show some type of spread widening, the buyside source added. Perhaps that will happen when the market reaches a point when it is scared about growth, he noted.

"But the market doesn't seem that worried, which worries me."

During the session, emerging market debt traded flat. The Brazil bond due 2040 was at 120.20 bid at the close, down 0.20. The Ecuador bond due 2012 was at 101¾ bid, up half a point. The Mexico bond due 2009 was unchanged at 101.80 bid. The Russia bond due 2030 lost 0.12 to 114.12 bid.

"Over the next few weeks, though, I expect it will be difficult for EM to continue to outperform as the reality of continued Fed tightening sets in and U.S. equities and the VIX [CBOE Volatility Index] continue to suggest a less robust economy and the potential for event risk," noted the analyst.

Investor waiting for political troubles

Meanwhile the buyside source said he is underweight in the market and has held that position for some time.

"It's been wrong," he noted, but he said he would not change his stance.

"Spreads are what they are. Sooner or later, they will correct.

"This is emerging markets. I don't care how much they say a new era this is," he remarked.

He added that a correction would not come from the Treasuries side but rather from the political side.

"In order for the Treasury market to get people to sell high yield, you can move from one to one, but you have to get yields much higher for people to give up on the spread product trade in general.

"It will either be the Fed hitting the point where people get worried about growth or figuring that commodities aren't going to help anymore," remarked the buyside source.

The market correction will most likely not be inspired by Brazil, added the source. Instead, countries such as the Philippines, Turkey and even Mexico would likely be the culprits.

"Mexican 10-year paper is trading at 100 basis points over and they do have an election coming up.

"Politics could be a big catalyst for a correction".

Indonesia to issue new paper

In the primary market, Indonesia is expected to issue a new deal in the next two to three weeks, according to a trader, who focuses on high-yielding Asian credits.

Indonesia has nicely come off the lows caused by the concerns over the rupiah, said the trader.

Indonesia's rupiah has rebound recently after coming under attack in response to high oil prices. In the past six weeks, there have been three interest rate hikes to shore up confidence in the country's currency.

"I think the market is strong at the moment," remarked the trader.

Indonesia 7¼% notes due 2015 closed Tuesday 100.0 bid, 100¼ offered, in the context of where they have been, he added. The spread is 300 basis points bid.

"It has performed pretty well. It has pulled back slightly in dollar-price and in spread-price. But it's still pretty well supported."

Out of Thailand, G Steel Public Co. Ltd. completed a roadshow last week for an offering of five-year bonds via UBS Securities.

The roadshow finished last week. There is no news on the deal, although rumors claim it is having trouble getting over the finish line and suggest the company might come back with a smaller issue, or possibly postpone the offering.

"You're definitely seeing a more rigorous approach from investors. It's not like early in the year where cuspy deals just offered a nice big yield and people just piled in," noted the trader.

There is plenty of issuance, so investors can pick and choose more. Also the Asian high yield market is not so well established, he added.

Rather, the Asian junk world is learning as it goes along and buyers are realizing that an incremental pick-up in yield comes with additional risk, he commented.

In addition, the universe of investors for Asian high yield is relatively small, and is more vulnerable in down trades to liquidity disappearing much more quickly, he observed.

The universe of investors that might look at an Indonesian sovereign deal is far bigger than the universe of investors that would look at a Thai corporate, the trader said, something that will be reflected in the price.

Talk on two deals

Also in the primary market, price guidance surfaced on two issues.

Russia's Industry & Construction Bank set initial price talk for a dollar-denominated offering of 10-year notes (Ba1//B+) in the area of 6 3/8%.

The issue will be structured as subordinated loan participation notes and lower tier II notes.

The notes will also be non-callable for five-years.

ABN Amro and Deutsche Bank are running the Regulation S transaction.

And the Bank of India talked its $250 million minimum offering of five-year notes at Libor plus 65 to 70 basis points.

The deal is being marketed this week in Asia, and is expected to price mid-to-late in the week.

Barclays Capital, Deutsche Bank and HSBC are the bookrunners.

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