Emerging market debt fueled by hints of Fed pause; handicapping Mexico's election

By Reshmi Basu and Paul A. Harris

New York, June 29 - Emerging market debt delivered strong returns Thursday after the accompanying statement to the Federal Reserve's decision to lift rates by 25 basis points provided financial markets the juice needed to spark a bull run.

The Fed noted that inflationary measures "have been elevated in recent months," but signaled that the pressure may be offset by slower growth due to higher rates and commodity prices. The market interpreted that to mean that the central bank may pause its current monetary cycle at its next meeting in August, thus ending 17 straight hikes since the Fed started to put the squeeze on monetary policy in June 2004.

As a result, core financial markets took off Thursday. The Dow Jones Industrial Average index posted its highest point gain since 2003. U.S. Treasuries saw the yield on the 10-year note fall to 5.20% from Wednesday's close of 5.25%

Meanwhile emerging market debt was able to build on the momentum gained from the previous session, noted a trader. On Wednesday, market sentiment improved on the back of an upgrade for Brazil by Fitch as well as by moves by Turkey's central bank to shore up the foreign exchange market, which included an intervention to sell dollars after raising key interest rates over the weekend.

During the session, the Brazilian bond due 2040 was up 1.30 to 123.05, 123.15 offered. The Argentinean discount bond due 2033 added 1.35 to 87.55 bid, 87.85 offered. The Venezuelan bond due 2027 gathered 1.25 to 117 bid, 117.60 offered.

Away from Latin America, the Russian bond due 2030 gained 0.75 to 105.75 bid, 106.25 offered and the Philippine bond due 2025 was higher by 0.88 to 122.50 bid, 123 offered. Finally, the Turkish bond due 2030 edged up 0.50 to 132 bid, 133 offered.

One source noted that Thursday's rally may be short lived.

"I expect relief rallies to be followed by profit takers," said the source.

Inside Mexico's deadlock election

In what is expected to be a highly contested Mexican presidential election, leftist candidate Andres Manuel Lopez Obrador is a smidgeon ahead of conservative ruling party candidate Felipe Calderon in polls. The market currently is pricing in an Obrador win, but by a very small margin.

There are three possible scenarios for Sunday's election, according to Alberto Bernal, fixed income analyst at Bear Stearns & Co. Inc.

The most market-friendly scenario is a win by Calderon while the second best scenario is if Obrador comes on top. And the worst-case scenario is that the margin for victory by either candidate is so small that no candidate is declared a legitimate winner, which could unleash allegations of voter fraud among other problems.

However under all possible scenarios, no candidate will be given a clear mandate to push through reforms or policies since congress will remain divided.

"None of the parties will get a qualified or automatic majority," noted Bernal.

"None of the parties are likely to get more than 42% of the vote, so it will be very divided. So whoever starts to govern will have to go and do politics and generate alliances and so forth."

Since mid-May, risk aversion has cranked higher on the tightening of global monetary policy. Mexico's external debt has given up some ground on the back of the rather complicated external environment. Additionally, bonds have been somewhat jolted by the political uncertainty landscape, noted Bernal.

"For example, the cost of five-year protection (CDSs) for Mexico has increased. Right now, Mexican protection is around 90 basis points. In January, it was 65," he observed.

"Nobody is pricing in a serious event. No one is pricing in that Lopez Obrador will act like a demagogue. That said, everybody is pricing a lack of interest from Lopez Obrador to evolve the structural agenda."

Nonetheless, Mexico has done a somewhat decent job of weathering the current market volatility but, as Bernal noted, the country has underperformed the market. The credit is down 4% while the market is flat.

"Mexico is a low-beta country, meaning that the relationship of Mexico against international volatility is really not that high. The price volatility of these bonds is really not that impressive. But I wouldn't get carried away and say that Mexico has done a great job."

But Bernal did concede that at the start of the year he expected to see more volatility stemming from election jitters.

"I was not expecting to see endogenous volatility from Colombia or Brazil, for example."

As in the case of other sovereigns across the asset class, investors have moved to the sidelines on the ratcheting up of risk aversion.

"In the local markets, the rates have in fact have reacted strongly to what has happened. For example, the 2024, which is an important bond in the local markets in Mexico, is trading around 9.5% in yield," said Bernal.

But that bond traded as low as 8% in March, meaning it has subsequently widened a considerable 150 basis points. That is a function of two drivers such as the less benevolent external environment as well as political uncertainties, he noted.

Investors will return to Mexico when the current mode of risk reduction comes down, but that may not happen anytime soon. A win by Calderon will be seen as more of an invitation to re-enter positions. On the other hand, Obrador will have to first prove himself to investors whereas Calderon will not, observed Bernal.

A Calderon victory will be accompanied by a mini rally. And whether that rally has much longevity will depend on the external environment.

Bear has Mexico at underperform

Meanwhile Bear Stearns has an underperform recommendation on Mexico.

"Our recommendation is not a function of us having a negative view in terms of the structure of the economy and the capacity of Mexico to remain an investment-grade country," he told Prospect News.

"Our underperform recommendation is function of that we have not been able to get excited about this story," he said.

There are lingering question marks on such factors as reforms, the divided congress and whether the leadership will be able to reach consensus, which is necessary for growth.

Despite election uncertainty, Mexico's sovereign debt rallied. During the session, the Mexican bond due 2026 gained 1.60 to 146.50 bid, 147.50 offered.

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