Emerging market debt at mercy of U.S. Treasuries; Brazil will not call C-bond

By Reshmi Basu and Paul A. Harris

New York, March 15 - Emerging market debt was doused Tuesday by declining U.S. Treasuries, while Brazil chose not to buy back its C-bond in an increasingly volatile environment.

Early in the session, Treasury yields compressed but then lost traction after a report came out showing that central banks were not responsible for the increase in foreign investment in government debt in the United States at the beginning of the year.

Instead, Caribbean-based hedge funds were behind the activity, according to the Treasury Department.

Also adding to the market's discomfort, net retail sales in December and January were upwardly revised. The retail picture was mixed as headline retail sales saw a 0.5% gain, below market expectations.

As a result, the Treasury market saw the yield on the 10-year note flirt with the 4.60% area, which it last visited in July. By the end of trading, the yield on the 10-year note stood at 4.54% up from 4.51% at Monday's close.

Emerging markets down again

Still nursing a hangover from declines the day before, price action in emerging markets was down across the board.

Early in Tuesday's session, the Brazil bond due 2040 was spotted at 113½ bid, down 0.60. As Treasury yields unraveled, the bond closed at 112.45 bid, down 1.65 on the day.

Even high oil prices could not insulate oil exporters such as Ecuador and Venezuela. In late morning, the Ecuador bond due 2020 was spotted at 92.80 bid, up 0.30. But by session's end, the Ecuador bond due 2030 had slid 1½ to 91 bid. The Venezuela bond due 2027 dropped 1.55 points to 101 bid.

Credits outside of Latin America were also hit. The Russia bond due 2030 dropped three-quarters of a point to 102¼ bid. The Turkey bond due 2030 was down 1¾ to 137¼ bid.

Looking ahead, pressure from U.S. Treasuries is a long-term problem, said an emerging market analyst. While inflows and fundamentals are now strong, there is no way of getting around the fact that higher rates in the United States mean a weaker fundamental picture for emerging market credits, particularly commodity exporters.

"EM inflows have been driven by low rates, and as rates go higher inflows will suffer," the analyst said.

"EM fundamentals are also in a way a product of low U.S. interest rates - low rates in the U.S. have driven high U.S. and Chinese growth, which in turn has boosted EM exports, especially commodities exports.

"As U.S. rates move higher, global growth will slow, and the export-led EM growth story may be challenged," he added.

Brazil C bond will not be called

Also Tuesday, Brazil's Treasury secretary Joaquim Levy said the country would not exercise an option to buy back its bond due 2014, also known as the C-bond.

At the end of Monday's session, there was a rumor that the Central Bank would recall the bond due 2014 in April, according to the Refco EM debt strategist.

The Central Bank has been laying the groundwork for a potential buyback, the strategist noted.

"In the past few weeks, the central bank has been actively purchasing dollars," he said.

There were two theories to explain the bank's motives. One theory suggested that Brazil would repurchase the C-bond.

"And the other one was a way to intervene in the market and take dollars away from the system, and give support to the price of the dollar as related to the price of the real because of the rapid appreciation of the real in the past couple of weeks."

"The market was creating the conditions for a call for the bond. As that happens, you have sellers of the bonds who wanted to avoid a loss and buyers of other bonds in the whole Brazilian curve."

The market was expecting to see $5 billion to $6 billion of the issue redeemed, said the strategist.

But in the morning, speculation was over.

"We considered that this was not the best moment to exercise the option, without that impacting whether this will be evaluated in the future," Levy said at a news conference.

During the morning hours, there was pressure on the C-bond, then it stabilized a little bit, the strategist noted.

In the late morning, the Brazil C-bond spotted at a 101.812, up 0.312. The C-bond closed around 101, about half a point lower from Monday's close, said the strategist.

The government had a call option to buy back the C-bond at par on April 15 and October 15.

Market expectations of a recall kept the C-bond hovering at the par area.

Brazil's Selic to go up 50 basis points

Brazil's Copom is expected to raise the Selic rate by 50 basis points from 18¾% on Wednesday.

The policy of the central bank is to increase rates to achieve the inflation target rate of 5.1%. Last year, the bank missed the target, said the strategist.

"The consensus is that they are going to keep on increasing rates until they stabilize prices," he noted.

Higher interest rates in a growing economy will result in pullback in economic growth, he added.

"In the past few meetings, the market has reacted positively to the increase in interest rates."

The central bank has sent a message that they are actively pursuing policies to control inflation, he noted.

"In Latin American countries, sometimes it is a contrary effect to what you see in the U.S. The fact that central banks are being tough on inflation - it's a positive," he remarked.

"On the other hand, it can also put pressure on the bonds."

At this point, it is difficult to forecast how Brazilian credits will react. But as long as the expectations are met, the hike alone should not cause a major disruption to the Brazilian curve, he remarked.

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