Insights

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Bond bears show their face after an extended absence

31 Mar 2021

Wikus Furstenberg, Refilwe Rakale, Yunus January, Daphne Botha, Aidan Kilian / Interest Rate Team

Economic & bond market review

Global bond market meltdown gained momentum

A spectacular meltdown took centre stage during February and March as rising inflation fears and expectations of monetary policy tightening took a firm hold amongst global bond market investors. The combination of improved general economic activity, a lull in COVID-19 infection rates, some progress with vaccination rollout programmes in a number of developed markets, and the approval of a massive US fiscal stimulus package fed growing concerns of higher future inflation and monetary policy tightening. Opinions expressed by the Federal Reserve and several other developed market central banks stressed that sustained elevated levels of inflation (and thus aggressive policy tightening) are not imminent, were drowned out by market noise. The tsunami of sellers caused the US 10-year Treasury yield to reach a high of 1.74% (a notable jump compared to the twelve-month low of 0.5%) dragging the entire global bond market with it in the process. This upward global bond yield correction, specifically in those markets where economic growth is gaining some traction and yields were hovering at unsustainably low levels like the USA, should be anything but a surprise. It could be argued that the US Treasury market correction still has some legs even in the absence of a significant inflation shock or a dramatic rise in official interest rates (Figure 1 refers).

Figure 1: The US Treasury sell-off was long in the making (Market yield versus Futuregrowth fair value estimate)

The US Treasury sell-off was long in the making
Source: National Treasury, Futuregrowth

Local market succumbed to the global bond sell-off

As is usually the case, the local market did not escape global developments unscathed. Even though the share of foreign investor exposure to South African rand-dominated government bonds dropped sharply after the peak of 41.4% in 2017 to 30.3% in February 2021, they remain the single largest investor group. This carries a significant risk to the local market, which once again was clearly demonstrated during the first quarter of this year. According to JSE trading statistics, indiscriminate foreign selling of rand-denominated government bonds, mainly in response to global events, totalled a whopping R38 billion during the quarter. Moreover, about 85% of total foreign selling was concentrated in the 3- to 10-year maturity band. This had a profound impact on market pricing despite that fact that local investors who, in contrast to foreign participants, were more constructive and accumulated bonds into market weakness.

Figure 2: Shareholding of RSA rand-denominated government bonds

Shareholding of RSA rand-denominated government bonds
Source: National Treasury, Futuregrowth

Market better priced for local monetary policy tightening

The spill over from the global reflation trade was not limited to the local bond market. Concern about elevated future inflation and its negative implication for monetary policy also found its way into more bearish short-term interest rate pricing. The steep upward slope of the local forward rate agreement (FRA) market curve clearly reflects this. At the time of writing, the FRA market reflected expectations of significant monetary policy tightening by the South African Reserve Bank (SARB) later this year and into 2022. As with the stand-off between monetary authorities and nervous market participants in the US, local investors opted to err on the side of caution by ignoring the consistent dovish message from the South African Reserve Bank (SARB). We also suspect that market participants are putting too much emphasis on global market developments, the potential direct and indirect impact on South Africa, and projections by the SARB’s own Quarterly Projection Model (QPM). The QPM projects no fewer than two repo rate hikes of 25 basis points each this year, followed by four more next year and again in 2023. However, it is very important to note that the SARB does not slavishly follow the interest rate path predicted by its QPM and has in fact deviated substantially from it in the past. It merely serves as one of many possible guides; a fact that is conveniently ignored by a jittery market and an issue that should probably be better communicated by the Bank.

In fact, the SARB reiterated its more neutral/dovish stance at the March Monetary Policy Committee (MPC) meeting by unanimously keeping the repo rate unchanged at 3.5%. The relatively benign longer-term inflation outlook, a fragile economic recovery and the rising risk of a third COVID-19 infection wave, convinced the MPC to refrain from prematurely sounding the proverbial hawkish horn. These considerations are expected to offset risks posed by the widely expected year-on-year inflation spike in the second quarter of this year, mainly the result of a low statistical base and the dramatic recent spike in crude oil prices following the spectacular collapse in the same period last year.

Figure 3: Forward Rate Agreement Market (Probability of a 0.5% change in short term interest rates)

Forward Rate Agreement Market (Probability of a 0.5% change in short term interest rates)
Source: National Treasury, Futuregrowth

Economic data releases broadly supportive of stable monetary policy path – for now

Latest actual inflation data continued to point to relatively benign underlying inflationary, specifically with respect to demand-pull forces. In February, both Headline and Core consumer inflation surprised on the downside with year-on-year rates of change of 2.9% and 2.6% respectively. While low to no medical aid insurance price increases represented the lion’s share, lower food price inflation and several other consumption items also contributed in a positive way. On the production side, the rate of inflation for final manufactured goods accelerated from 3.5% in January to 4.0% in February. The bulk of this increase was due to a widely expected lift in fuel prices following the sharp increase in crude oil prices. Encouragingly, like developments at the consumer level, food producer inflation also slowed, in turn pointing to a fading in the upward momentum of food prices, in general. That said, all eyes are now set on the widely expected jump in the rate of inflation in the next few months.

Total private sector credit extension remains weak with a 2.6% year-on-year increase in February, and the total loans and advances sub-component now at 1.7% (from a recent trough of 0.6% in the third quarter of last year). While slowly accelerating, this rate of increase is too weak to feed relative price changes into sustained price increases across the board.

The external account continued to deliver good news, with a large trade surplus for the first two months on this year - the combined result of strong export performance while imports remain relatively subdued. The difference between the pre- and post-pandemic periods is striking. In the first two months of this year compared to last year, goods exports were 14% higher year on year, in contrast to the 1% decline in goods imports. This resulted in a R41 billion trade surplus for the first two months of this year, compared to a R10 billion surplus for the same period last year.    

Fiscal authorities strike the right chord, but implementation risk looms large

In his 2021 budget speech, the Minister of Finance confirmed that this administration is serious about its intention to turn the fiscal ship away from the proverbial cliff. The deceleration of debt accumulation by means of higher-than-expected tax revenue collection and focus on expenditure reduction rather than simply raising taxes is encouraging. This improvement, together with its intention to tap into cash balances, enabled National Treasury to announce the reduction in the size of the weekly primary bond auctions with effect 1 April 2021.

However, the planned fiscal consolidation carries significant execution risk, particularly when it comes to the intended reduction of the enormous wage bill. Although the debt to Gross Domestic Product (GDP) ratio is now estimated to peak at a lower level of 88.9% in 2025/26 (vs the medium-term estimate of 95.1%), it is still extremely high and unsustainable for a number of reasons, especially in light of our (and National Treasury’s) economic growth outlook. We also remain concerned about the more bullish revenue estimates in the fiscal years beyond 2020/21, given that these are not backed by significantly higher real GDP growth, improved tax buoyancy or any additional tax measures. For more detail on our take on the recently tabled budget please read Is the ailing fiscal position finally receiving a lifeline?

Figure 4: Planned fiscal improvement faces significant execution risk

Planned fiscal improvement faces significant execution risk
Source: National Treasury, Futuregrowth

Nominal bond returns took a turn for the worse, while inflation-linked bonds put in a star performance

In stark contrast to the previous three quarters, rising bond yields caused a significant underperformance of nominal bonds relative to inflation-linked bonds and even cash. On a net basis, the FTSE JSE All Bond Index (ALBI) rendered a return of -1.74% for the first quarter of this year. The biggest negative contribution was from bonds in the 7- to 12-year maturity band, which returned -2.22%. 

Conversely, inflation-linked bonds rallied across the real yield curve, owing to inflation-hedging demand. As a result, the FTSE JSE Government Inflation-linked Index (IGOV) rendered a very strong return of 4.66%. The combination of reasonable valuation and expectations of higher inflation in the near term (which will boost the inflation carry offered by these bonds) served as catalysts for renewed interest in this asset class. This performance was well in excess of the 0.85% rendered by cash during this period. 

Figure 5: Bond market returns (periods ending 31 March 2021)

Bond market returns (periods ending 31 March 2021)
Source: JSE, Futuregrowth


// THE TAKEOUT

The sharp increase of yields in some of the major global bond markets (particularly the US) backed by improved economic growth prospects, fears of higher inflation and by implication future monetary policy tightening, turned foreign investors into aggressive net sellers of South African nominal government bonds. This contributed to significant bond market weakness as bond yields across the curve increased. In stark contrast, inflation-linked bond yields traded lower, leading to strong returns for the quarter. Local monetary policy rate expectations, as reflected by the forward rate market, turned even more bearish. This is in stark contrast to a cautious yet neutral policy message from the central bank at its latest MPC meeting in March. On the local fiscal front, government reiterated its intended fiscal consolidation with the tabling of the latest national budget. However, the well-laid-out plan is still fraught with challenges and thus execution risk. As a result, it failed to offset the impact of jittery global sentiment.

 

Key economic indicators and forecasts (annual averages)

 

    2017 2018 2019 2020 2021 2022
Gobal GDP   3.4% 3.3% 2.6% -3.6% 6.6% 4.5%
SA GDP   1.4% 0.8% 0.4% -7.0% 5.0% 2.0%
SA Headline CPI   5.3% 4.6% 4.1% 3.3% 4.0% 4.5%
SA Current Account (% of GDP)   -2.5% -3.5% -3.2% 2.2% 1.0% -1.0%

Source: Old Mutual Investment Group