Spreads on emerging market debt, particularly Latin American sovereigns, are poised to widen out substantially during the first half of this year if the Federal Open Market Committee raises the Fed Funds rate aggressively, said fixed-income market participants.
The Brazil 8% of '40, which is considered the benchmark for liquid Latin American names, was trading at 118 5/8 at the end of December but fell to 114 3/8 mid-week following the release of the minutes from December's FOMC meeting which announced the Fed may not maintain its "measured" approach to raising rates this year. And emerging market officials said it could fall further.
"Rates moving up will tighten global liquidity conditions, which was what was driving such tight EM spreads, not credit fundamentals," said Christian Stracke, head of emerging market research at CreditSights, an independent research firm. He expects the Fed Funds rate to hit 3 1/4% and for the damage to be concentrated in countries with high external financing levels and low internal reserves, such as Brazil, the Philippines and Colombia.
The J.P. Morgan Emerging Market Bond Index (EMBI) kicked off the New Year around 360 basis points over Treasuries and Stracke speculates it will widen out to 475-500bps over by the end of the second quarter. Brazil has around $240 billion in government and private sector debt outstanding and its portion of the EMBI's sub-index traded around 400bps over Treasuries at the beginning of January. He anticipates it will go out to 550bps over in the first half of this year.