Market Opinion
July 3 2005
Fixed Income - article ID 4236
Can EM Debt Rally Further?
When a particular market has rallied a long way over a reasonable period of time, and is in fact trading at all-time highs, questions concerning further out performance are only natural. With the EMBI+ trading at around 300bps over US Treasuries, the market may be somewhat complacent about emerging markets risk. We would say this is not the case.
Readers will know that we have been impressed with the underlying economic fundamentals of emerging countries for many months, and we still are. The outlook for sustainable levels of real GDP is positive, given a continuation of buoyant export revenues from high commodity prices, increasing levels of domestic demand, and prudent monetary and fiscal policies. The ongoing rise in foreign exchange reserves is allowing for a significant improvement in debt management, with various buybacks, restructurings and pre-financing being enacted by several governments. This will lead to yet further recognition by the ratings agencies, with a host of sovereigns on positive outlook.
However, a key short-term variable is the US Treasury market. The reversal of the US 10-year yield last week, taking it back above 4.00%, could mean that it is forming a base in the 3.92-4.00% area. The level to watch on the upside is 4.16%, a break of which would send the 10-year yield back to the high 4.20s. US short rates are set to move higher, given Mr Greenspan’s more upbeat view of the US economy, which may well cause the long-end to sell-off slightly.
That said, we are not overly concerned about US Treasury yields. We feel there is sufficient demand from Asian central banks and oil producers looking for a safe-haven to invest excess levels of foreign exchange reserves and from G7 pension funds to prevent yields from spiking, thereby allowing for further curve flattening.
As a result, while the short-term movements of the US Treasury market may well stop investors from taking EM debt into a new trading range just yet, we think that the global search for yield will provide enormous support to the asset class. With this in mind, spreads could even halve from current levels over the coming years.
The key beneficiaries will be the more fiscally sound credits, such as Russia, or those that are making steady improvements on the fiscal front, such as Brazil. Sure, political risks will provide bouts of volatility, but it is the ability to pay back debt which is the most important thing to focus on. Over the coming days, though, watch US Treasury yields. If, of course, they fall back, EM debt can fly.
As for the bund future, key support exists in the 122.70 to 122.85 area. A fall through these levels will send the instrument down towards 122.00. If the market holds the 122.70 area, though, then we see no reason for the major uptrend not to continue.
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