Emerging market spreads tighten as Fed lifts rates 25 bps; Sino-Forest prices $300 million

By Reshmi Basu and Paul A. Harris

New York, Aug. 10 - Spreads on emerging market paper tightened as Treasury prices fell on the Federal Reserve's hawkish outlook regarding the softness of the U.S. economy.

The Federal Reserve raised the federal funds target rate by 25 basis points to 1.5%, surprising no one.

Instead, the real story of the day was how the Fed would explain the apparent "soft patch" in the U.S. economy and whether it would back down from its "measured pace" strategy for raising rates.

In its statement, the central bank's Federal Open Market Committee said the economy's slowdown was due to the rise in energy prices.

"The economy nevertheless appears poised to resume a stronger pace of expansion going forward," the Fed said in its statement.

"With underlying inflation still expected to be relatively low, the committee believes that policy accommodation can be removed at a pace that is likely to be measured."

Overall, emerging market paper was slightly down in response but outperformed the U.S. Treasury market. The JP Morgan EMBI Index fell 0.07% but its spread to Treasuries tightened five basis points to 456 basis points.

More hawkish, says buy-side source

The Fed's statement was slightly more hawkish than the previous one, according to a buy-side source.

"But I don't know why they continue to go with this 'balanced.' I think the statement did not allow them room to maneuver," he said.

The Federal Reserve maintained its view that the outlook for growth and inflation is balanced, as they have been saying for a while, the source added.

As far as emerging markets are concerned, however, the buyside source said economic numbers will be the driving force - and the Fed can do little about, for example, three straight weeks of poor initial claims numbers.

"I think it's really more the data," the source noted.

Meanwhile, markets performed well off the Fed's bullish comments.

"I didn't think there was that much change in the statement, but apparently the market likes what they've heard," said the buy-side source.

"Stocks have rallied pretty aggressively, the dollar has strengthened.

"EM markets seem a little bit bid."

Sino-Forest prices

In the primary market, Sino-Forest Corp. priced $300 million of guaranteed senior notes due 2011 (Ba2/BB-) at par to yield 9 1/8% via Morgan Stanley.

The buy-side source took part in the offering, given the attractiveness of China and timber as a commodity.

"I don't believe in the hard landing in China," said the buy-side source. "I don't know if it's a hard or soft landing, but a landing in China is 4%.

"I still like the China story. There's 1.2 billion people there.

"Assuming, they don't completely mismanage their economy, things are getting better. And so you always have to have growth.

"The company is relatively low leverage. And timber is an interesting commodity. It's renewable, but it has a lot of the same characteristics of gold and energy," he added.

After being free to trade, the new bond performed well, moving up to 101½ bid, 102 offered from its par issue price.

Brazil up on Lula

Meanwhile for the first time this year, Brazilian President Luiz Inacio Lula da Silva's approval figures rose. The rating for Lula's government jumped to 38.2% in August from 29.4% in June, according to pollster Instituto Sensus.

That news combined with Federal Reserve's bullish view on the economy pushed up Brazilian paper.

In trading Tuesday the Brazilian C bond was up a quarter of a point to 95 bid, while the bond due 2040 added half a point to 100¼ bid.

Crude oil touches $45 a barrel

Despite reaching new record highs, oil prices had a minimal effect on emerging market paper - in either direction.

"I don't see a pattern where the oil countries are outperforming," observed the buy-side source.

"Russia is doing about average. Venezuela is about average.

"Oil at these levels is a negative for global growth perceptions, if nothing else," he noted.

And the bombing in Turkey did little to impact its paper. Simultaneous bombings hit two hotels and a gas depot in Istanbul. Two are dead, including a Turk and an Iranian.

"Turkey seems to be doing okay. The currency has strengthened," said the buy-side source. "It's outperforming today - that's the beta trade."

High beta rally

The dismal job numbers from Friday ignited a high beta credit rally. Investors have been rethinking whether or not they should increase their exposure, given the low interest rates produced by the strong rally in Treasuries.

"I'm a little skeptical about this idea that high beta is going to be all the rage just because of the July jobs report," said an emerging market analyst.

"EM can't have it both ways: if rates are going to be low, it's because of a weak U.S. economy, and if the U.S. is not so weak, then rates will go higher again.

"Either way, high beta credits will suffer; a weak U.S. economy will hurt equities and raise risk aversion, and higher rates will reignite illiquidity fears.

"I think this bid for high beta has been mostly a knee-jerk reaction to lower rates, but these lower rates have to be seen in context," he argued.

While emerging markets have continued to rally, it is just making valuations that much worse, according to the buy-side source.

"We've owned Brazil for awhile. If anything, we've been adding to Russia because it offers phenomenal value," the source said.

"We haven't been involved in Turkey or the Philippines - the higher debt countries - because we have been worrying about the debt levels of those countries, he added.

"Valuations are still not there, but the market appears to be in a relatively good mood."

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