JP Morgan note spurs sell off; Brazil's troubles generate market jitters

By Reshmi Basu and Paul A. Harris

New York, May 26 - A JP Morgan note urging investors to reduce their positions in some emerging markets sovereign bonds to underweight initiated a broad sell-off in trading Wednesday.

"When the market is as sensitive as it is now it doesn't take much news to move the market," said a trader.

The bank suggested that investors reduce their position to underweight in Brazil, Turkey and Ecuador.

"The last couple of days, we had a little better sentiment in the market. Yesterday, prices were higher between 100 to 200 basis points towards the curve," said a debt strategist at Refco EM.

"Then this morning, after the JP Morgan report came out saying they were underweighting some of their positions in Brazil. The market lost ground," he added.

This was another blow to Brazil's capital markets, said the trader.

"There's no good news for Brazil."

Meanwhile, Korea's largest banking network National Agricultural Cooperative Federation postponed its planned offering of $350 million 10-year subordinated bonds due to market conditions.

"Not enough buyers," said the trader.

The deal was expected to price early this week.

In secondary trading, the Republic of South Africa's $1 billion 6½% 10-year global bonds was weaker in Wednesday's trading. On Tuesday, the issue priced at a spread of 195 basis points.

One trader said trading levels for the new deal were at a spread of around 199 basis points.

Barclays Capital and JP Morgan ran the books for the off-the-shelf issue. The co-manager was Rand Merchant Bank. The bonds (Baa2/BBB) priced to yield 6.682%.

Brazil's catch-22

Meanwhile, concern is growing that Brazilian president Luiz Inacio Lula da Silva's may be forced to loosen the country's tight fiscal policies as his popularity continues to slip, thereby losing much needed capital market support.

Scandals have plagued Lula this month ranging from his call to expel a New York Times reporter for writing about his alleged drinking to federal charges pending against his long time friend and ally Mauro Dutra. Dutra is alleged to have embezzled $300,000 in government job training funds through an organization that he operated.

"First, there's a political situation in Brazil," said the debt strategist at Refco EM.

"There has been perception that President's Lula's honeymoon is over. Although his popularity is still high, it is not as strong as it used to be.

"He has a very broad coalition in Congress and he needs to pass certain reforms in order to maintain the support from other political parties," he added.

Another aspect has to do with the risk aversion towards emerging markets due to possible higher interest rates in the United States.

Brazil is caught up in a vicious cycle. If the country veers off its orthodox economic program, it will likely lose favor with the capital markets. And without that support the country will have a hard time paying down its debt.

"Higher interest rates in the U.S. will tend to undermine the country risk," said the debt strategist. "They require capital flows in their country in order to pay their obligations."

The markets are watching Brazil's economic indicators for pointers as to the future direction of the country's economy and political policies.

On Tuesday, Brazil reported that the jobless rate increased in April to its highest level in more than two years. Unemployment rose to 13.1% from 12.8% in March and 12.4% a year ago for the countries' six largest metropolitan areas.

Coming up on Thursday is Brazil's first quarter GDP figures and the release of the minutes from the Monetary Policy Committee, which held interest rates steady last week.

Mexico tied to Treasuries

Meanwhile, the debt strategist expects Mexico to continue to perform relatively well, helped by the U.S. economy and high oil prices.

That is in contrast to some countries which have rallied on the high oil prices. Venezuela benefited from demand for its paper a couple of weeks ago - but is not likely to gain much further, according to the strategist.

"We saw some profit taking out of Venezuela," noted the debt strategist.

Mexico's performance, meanwhile, will track the performance of the U.S. Treasury market going forward.

"It has also been punished by the risk aversion to the emerging markets," added the debt strategist.

Nonetheless the recent economic data support the view that inflation is stable and "the perception in Mexico is that as long as the economic recovery in the United States persists, Mexico will do okay."

And furthermore, Mexico is an oil-producing country and its debt will continue to benefit from higher oil prices, he added.

Also on the oil front, market rumor is speculating about a ratings upgrade for Russia

"And I think that is directly related to oil prices," said the strategist.

Investors go short

Overall, emerging market flow indicates a rotation towards the shorter part of the curve, according to the debt strategist.

"Those dedicated accounts that have positions are moving to the shorter part of the curve.

"When you do have an environment of higher interest rates, the best way to protect your assets is to reduce your duration. By reducing duration, shortening the length of the maturity," he added.

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