Argentina May See Currency Fall, Analysts Warn

After defaulting on its bonds for the second time in thirteen years last week, Argentina is in danger of seeing the value of its currency fall even further, which will only make it harder for the nation to honor its outstanding debts.

After defaulting on its bonds for the second time in thirteen years last week, Argentina is in danger of seeing the value of its currency fall even further, which will only make it harder for the nation to honor its outstanding debts.

In a research note released late last week, JPMorgan economist Vladimir Werning cautioned that currency devaluations inevitably follow defaults, and this was no exception. Further, Werning says the default could destabilize financial markets beyond Latin America, and augment global weakness in both bond and equity markets. “The government’s stance on the holdout conflict raises risks to both domestic financial stability and macroeconomic performance if an agreement with holdouts is not reached,” Werning wrote.

The Latin American nation has already seen its currency fall in value, particularly as concerns over the debts peaked earlier this year. In January, the currency fell over 11% overnight at a time when panic over emerging markets caused global equity markets to destabilize. Fearing an overabundance of capital had fled to unstable markets in a hunt for yield, many traders sold off holdings to mitigate risks.

Temporary Headwinds

That January sell-off was short-lived, and the Argentine peso has since stabilized as Argentinian stocks rallied. Demand for Argentinian bonds in recent days has not abated, with long-term benchmark bonds due 2033 still trading at their highest point in three years.

Meanwhile, Argentina’s stock market has rallied; the Global X Funds ETF that tracks the Argentinian market, ARGT, is up over 12% for 2014. Some economists believe that Argentine companies may get a short-term boost from the devalue currency, which will make exports cheaper.

Still, economists worry that the government will need to find a solution with its creditors quickly. If it does not, a devalued currency could cause the government to run out of reserves, which would bring the nation’s production to a standstill. “Exchange-rate pressures would likely increase as international reserves would decline at a faster pace and economic activity would face additional headwinds” said Mauro Roca, an economist at Goldman Sachs.

Bond Market Spreads

With demand for Argentinian bonds remaining strong despite the default risk, the nation’s credit is following a larger trend of rallying bonds in a yield-starved environment. Some analysts worry that spreads between high yield debt and U.S. treasuries has gone too high, and bonds are due for a pull back.

Spreads between high yield and U.S. Treasury yields have broken the year’s trend and have begun to rise after long-term Treasury rates hit a ceiling in early 2014. After spiking in January, 10 year U.S. Treasuries have fallen from just over 3% to around 2.5%, and inflows caused high yield corporate and sovereign debt yields to fall even faster.

This yield-chasing behavior caused spreads between high-yield and U.S. Treasury debt to decline. The BofA Merrill Lynch US High Yield Master II Option-Adjust Spread Index, which tracks the relationship between high-yield debt and U.S. Treasuries, fell to an all-time low in June 2014 as junk bond ETFs reached year-to-date highs. Since then, spreads have risen as junk bonds fell in value.

Some analysts worry that the rising value of junk bonds as a result of falling interest rates in 2014 is unsustainable, and bonds must fall to 2013 levels as the U.S. government begins to taper. It remains unclear to what extend this may impact Argentinian debt, but falling prices in foreign junk bond markets will offer traders an alternative to Argentinian bonds just when fears of devaluation, default, and domestic instability provide additional risks in the market.

With Argentinian bonds falling on Thursday and Friday, many analysts fear further declines are inevitable. In early Monday morning trading, Argentinian government bonds due 2033 had already fallen over 1%.