Emerging market debt sinks on increased risk aversion; high beta names slide

By Reshmi Basu and Paul A. Harris

New York, May 12 - Emerging market debt saw a heavy sell off on increased risk aversion Friday, as the asset class tracked both global equities and U.S. Treasuries lower.

Friday's session continued the trend set in the financial markets Thursday, when there was a sloppy trading session following the release of Wednesday's Federal Open Market Committee statement, which left the door open for more rate hikes by the Federal Reserve.

Both U.S. equities and Treasuries were nailed Friday. The Dow Jones Industrial Average index bled 119.74 points to close at 11,380.99 while the yield on the 10-year Treasury note jumped to 5.18%, up from 5.15% Thursday.

All across the board, sovereigns slid on a dollar-basis with many high-beta credits taking the blunt of the downturn, noted a trader.

During the session, the Brazilian bond due 2040 declined 1.30 to 125.80 bid, 125.05 offered. The Argentinean discount bond due 2033 lost 1.95 to 95.80 bid, 96.25 offered. The Colombian bond due 2033 shed 2.25 to 133 bid, 134 offered.

The Mexican bond due 2026 fell 0.50 to 149.50 bid, 151.50 offered. The Turkish bond due 2030 gave up 2.50 to 146.875 bid, 147.375 offered. And the Venezuelan bond due 2027 dropped 2.10 to 122.50 bid, 123.30 offered.

Up until now, emerging markets have performed well, driven by the commodity story, observed Alberto Bernal, fixed income analyst at Bear Stearns & Co.

"High commodity prices imply that the dollar inflows into these countries remain at very comfortable levels," he said.

More dollars equal stronger currencies, which means that investor holdings will appreciate, theoretically a win-win situation. But there is a downside. On a day-to-day basis, the cost of servicing the Latin American debt is changing with the Fed. Since a percentage of Latin America's debt is denominated in dollars, the price of the liabilities moves in line with global interest rates.

"And interest rates are going up in the world because of robust growth in the U.S and because of the view that the inflation outlook has deteriorated a bit on the back of very high energy prices, so the region has been hit from that side of the story," emphasized Bernal.

EM watching data day by day

Whether or not the recent spread widening is the start of a sell-off is difficult to forecast. The market has become increasingly U.S. data driven, which means its performance will be "day by day."

"We are in a very complicated territory right now. The Fed has made it very clear to the markets that this is a complicated story because data dependency means that the story changes from one day to the next," Bernal noted

And Friday was a perfect example of how data is now driving the market.

The Labor Department reported that U.S. import prices saw an unexpected jump, which triggered a sell-off on speculation that the figures point to higher inflation. And then a few minutes after the report, the University of Michigan's reading of consumer sentiment for May came in weaker than expected, which implied less growth, noted Bernal.

"You have less growth. And at the same time, you have higher prices. Less growth should generate less price pressures. You have two conflicting scenarios vying to see which one wins. It changes every day."

Furthermore, Latin American investors have had to become U.S. economists in order to gage the direction of where Latin American assets are heading.

Bernal said that he was expecting to see a weaker Brazil, given the upswing in U.S. Treasury yields. But Brazil has remained resilient because of its strong fundamental story as well as the fact that the country's upcoming presidential election is not creating investor jitters. The market will look favorable upon whoever wins the election.

"The performance of the asset class, especially Brazil, has been impressive so far. That's an interesting, somewhat unexpected occurrence," he told Prospect News.

Range-bound market

Meanwhile the market has been range-bound and will probably remain so. Nonetheless, the region's reaction to a jump in Treasury yields has been quite bullish so far.

"For example, if U.S rates go up by five basis points, Brazilian rates go up by, say, six basis points, so there's only a widening of spreads of one basis point, which is an unprecedented issue.

"The region has been able to hold ground on a spread basis, which is impressive. It's a good omen," Bernal remarked.

And the reason why the market has continued to push ahead is due to the solid technical story.

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