Following a rather protracted period during which political and market events introduced some distortion to the interest rate cycle, a level of “normality” returned by the end of 2017. What do we mean by “normality”, you may ask? Simply put, the focus has returned to growth and inflation drivers, as opposed to political events, as influencers of monetary policy and the interest rate cycle.
WRITTEN: WIKUS FURSTENBERG, PORTFOLIO MANAGER
Considering all the various drivers of the interest rate cycle, our view of where we are at the time of writing (January 2019) is indicated below. However, of greater importance is where we are heading - and, more specifically, how the yield curve will behave.
Figure 1: The Interest Rate Cycle - Simplified
WHAT IS THE NEXT BIG YIELD CURVE ADJUSTMENT?
While it goes without saying that financial markets never move in an orderly fashion, it is clear that the dominant yield curve change over the past year or two was for the yields of longer-dated nominal bonds to rise to higher levels, while the yields at the short end still tracked the repo rate lower, until as recently as March 2018. This is also known as bearish yield curve steepening. Two other important drivers of the bearish steepening had been the precarious South African fiscal situation and the rise, until recently, of US Treasury yields. While a failure to improve the fiscal outlook could force the market back into bearish yield curve steepening mode, it would be prudent to take a closer look at other potential yield curve scenarios.
The next yield curve scenario in line is called bearish yield curve flattening. This scenario received a much expected boost with the repo rate increase announced by the SARB at the November 2018 Monetary Policy Committee Meeting. Being the first repo rate hike in this cycle, the market is priced for more monetary policy tightening in the near term. One way of illustrating this it by taking a look at either the slope of the spot money market yield curve, specifically the yields at which bank negotiable certificates of deposits (or simply fixed rate term deposits) are offered, or the forward market for money market rates. We are of the view that the current expectations of policy tightening, in light of a weak economic growth and rather benign inflation outlook, are probably a tad too aggressive. This implies that the scope for significant bearish yield curve flattening is limited to perhaps one more repo rate increase of 25 bps.
Figure 2: Market for bank fixed rate term deposits (Negotiable Certificates of Deposits or NCD’s)
(In our minds, the slope of this yield curve is too steep, thus limiting the scope for sustained bearish yield curve flattening)
Sources: Bloomberg, Futuregrowth
DRIVERS OF THE NEXT BIG YIELD CURVE ADJUSTMENT
Given that the market has largely priced in bearish yield curve flattening, our focus has already shifted to the next potential major yield curve change, that is bullish yield curve flattening (refer back to the interest rate cycle graphic). In this case, the yields of longer-dated nominal bonds decrease in anticipation of lower inflation, the end of the monetary policy tightening cycle, and, in this case, some indication that the SA fiscal situation is at least stabilising, albeit remaining rather precarious. As this unfolds, longer-dated bonds will render a higher return than short- and medium-dated bonds (remembering that bond yields fall when prices rise). The potential drivers of such an outcome are considered below.
US Treasury market yields have approached our fair value estimate
Sustained strong economic growth and a significantly reduced unemployment rate, combined with moderate inflationary pressure, afforded the US Federal Reserve an opportunity to significantly normalise the level of its key interest rate in the course of 2018. In the process, the US Treasury market has drifted higher (weaker) to more realistic levels compared to the lows reached in 2017. Although it could very well drift to a higher level, we feel comfortable that the market now does most of the work by appropriately pricing in this shift, especially since we are not convinced that this cycle is going to be as strong as in the past, mostly due to strong disinflationary forces. With US yields more contained, and in light of the fact that this remains the global benchmark, upward pressure on local yields from this source would be significantly reduced.
The rand has depreciated sharply and appears to be oversold
The rand has weakened significantly since the end of the first quarter of 2018. While nobody can predict currency movements with any degree of certainty, we can safely state that the rand seems oversold relative to our estimate of its purchasing power parity. While some of the recent weakness admittedly might still find its way into higher prices of local goods and services, weak local growth might offset most of the negative relative price changes.
Figure 3: USD/ZAR exchange rate based on purchase power parity
(Based on the inflation differential between the US and SA, the rand appears undervalued and could potentially strengthen0
Sources: Bloomberg, Futuregrowth
Limited rand depreciation pass-through suggests a strong disinflationary backdrop
As clearly illustrated in the chart below, the inflation rate and exchange rate have decoupled. Of course, the combination of subdued global inflation, weak local economic growth and strong competition in the retail sector has an important role to play. Unless economic growth picks up significantly, and in a very short space of time, we believe that the inflation outlook will remain relatively benign over the next twelve months. This, in combination with a fairly hawkish central bank, is supportive of an eventual decrease of longer-dated nominal bond yields.
Figure 4: A very benign underlying inflation trend
(Pass-through from significant rand depreciation has been limited)
Sources: OMIG Economic Research Unit, Futuregrowth
Foreign investors have reduced their holdings of RSA local currency government bonds
The significant net selling of SA bonds by foreign investors could be attributed to various factors. These include risk aversion in response to significant emerging market turmoil, the gradual draining of excess global liquidity and SA-idiosyncratic factors. Noteworthy is the fact that this selling was concentrated in nominal bonds with a term to maturity of eight years and longer. With this large and important section of the broader investor base significantly reducing their holdings of longer-dated bonds, future potential selling pressure is lessened and, if market conditions indeed become more favourable, these investors may be lured back. It must be stressed that this is a technical market driver. As a prerequisite, the fundamental drivers need to fall in place.
Figure 5: Foreign ownership of RSA Government bonds (percentage of total)
[Foreign investor share of the total has declined from the peak]
Sources: National Treasury, Futuregrowth
The risk to fiscal consolidation remains, but the cloud is not as dark as it was last year
Of all the drivers mentioned, this is the most significant hurdle for bullish yield curve flattening. Our thoughts on the link between sustained low economic growth and the negative impact on the fiscal situation, mainly via the tax revenue channel, and the resultant threat to the country’s sovereign risk profile, are well telegraphed. The question is: what may contribute to a change to our thinking? Clearly, a recovery in the growth outlook, tax efficiency gains at the South African Revenue Service and some improvement in expenditure management at all levels of government will improve the outlook for much-needed fiscal consolidation. In our minds, this is a significant red light that might continue to overshadow the more favourable factors listed above. Even so, a rate of change in the right direction may very well suffice for a more muted curve flattening, considering how much negative news has been priced in at this point in the cycle.
Figure 6: National government’s debt to GDP ratio versus yield curve steepness
(A sustained increase in the government’s outstanding debt to GDP ratio may exert upside pressure on long-dated yields and thus cause the yield curve to bear steepen as opposed to bull flatten.)
Source: National Treasury, Bloomberg, Futuregrowth
OUR RESULTANT INVESTMENT STRATEGY
Considering the factors discussed above, we are cautiously optimistic about the rising probability of a scenario where long-dated bond yields decrease at a faster rate than short- and medium-dated bond yields in the medium term. This may also be seen as a reflection of at least some recovery, with the possibility of lower inflation towards the back end of 2019 and a slightly better economic growth outlook. For this reason, we have used bouts of market weakness over the past few months to reduce our initial significant underweight position in long-dated bonds.