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Central banks hold steady in the midst of an inflation surge

31 May 2021

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

Economic & bond market review

Latest inflation readings impact significant base effects

Without exception, developed and emerging economies around the globe had to process the significance of headline inflation spikes in the past few months. In South Africa, the March year-on-year rate of increase for the Headline Consumer Price Index (CPI) and Producer Price Index (PPI) for final manufactured goods surged by 4.4% and 6.7% respectively. A common denominator across the globe (including South Africa) is the influence of base effects one year after a dramatic crude oil price collapse, accentuated by the strong crude oil and general commodity price rebound since then. A similar trend played out in food prices, while pandemic-induced supply-bottleneck price increases were also added to the mix. While a significant inflation spike had been well telegraphed and was thus widely expected, headline inflation data generally still managed to surprise on the upside, testing the nerves of investors and central bankers alike. In contrast, measures of core inflation remained relatively well contained in the majority of cases, supporting the view that headline data distortions caused by the pandemic in the past twelve months are most likely transitory.       

Not only inflation data is distorted

While many eyes are fixed on inflation data as the primary leading indicator of near-term central bank policy response, the importance of other economic data releases should not be downplayed. As an example, the latest weaker-than-expected US labour and retail sales data was distorted by various factors, including unusually generous unemployment benefits, which may dissuade people from actively seeking jobs. These distortions should therefore be recognised by policymakers (particularly central banks) to ensure that the correct underlying trends, both in terms of economic activity and inflation, are identified and the most appropriate policy responses applied.

Figure 1: Up, up, but not away…yet
(SA Headline CPI forecast)

Source: OMIG, Futuregrowth

While some have begun adjusting their policy stance, the majority of central banks are still singing from the same page

Most central banks have followed the path of policy response caution. Globally, monetary authorities have endeavoured to strike an appropriate balance so as not to jeopardise the economic recovery currently under way. In this context, the word “transitory”, with specific reference to the current inflation surge, has received a new meaning. While the most recent monetary policy minutes of the US Federal Reserve unsurprisingly revealed information eluding to a discussion about higher rates and a slowdown in its bond-buying programme (also referred to as tapering), it was very clear that the central message remains one of no policy response in the near term. In a similar vein, the South African Reserve Bank (SARB) expressed the view at its May Monetary Policy Committee meeting that the recent surge in inflation had been widely expected, mainly due to technical reasons. As a result, the current surge is not yet viewed by the bank as a threat to longer-term inflation stability, especially considering the persistent wide output gap and the fact that, even when incorporating the surge, headline inflation is expected to remain well within the 3-6% target band over the forecast period. However, some monetary authorities, especially in emerging markets, are busy adjusting their policy stance to become less accommodative.

Latest sovereign rating agency reviews convey a similar message

The central message of the South African sovereign credit reviews released in May by international rating agencies, Moody’s, Fitch, and Standard and Poor, was largely aligned. In summary, improvements in growth prospects, commodity prices, current account balance, and better-than-anticipated revenue collections relative to the previous round of credit rating reviews in November 2020, all contributed to staving off further negative rating action. The agencies nonetheless expressed concern about the ability to return to a higher, sustainable economic growth path in light of structural hurdles and thus to consolidate the dire fiscal situation. Unsurprisingly, execution risk related to the intention to reduce the size of the bloated public sector wage bill had, once again, been flagged, especially considering the recent strong stance by organised labour regarding the expectation of above-inflation increases. While very few market participants feared negative rating action in May, the market nonetheless welcomed inaction. This, together with improved global risk appetite, as central banks managed to temper inflation-induced fear a tad, contributed to lower local bond yields. That said, the proverbial jury is still out on the outlook in the longer term, with attention already nervously turning to the next scheduled round of reviews due in November this year.

Figure 2: South Africa is not priced for another round of rating downgrades 
Sovereign credit default spreads versus Standard and Poor’s sovereign ratings

Source: Bloomberg, Futuregrowth

Better rand performance partly mirrors a strong external trade account

The revival of global economic growth, the commodity price surge which includes South Africa’s main mineral exports, and a weaker US dollar, combined to allow the rand to regain more ground – and the currency turned out to be one of the top-performing currencies globally in the past month. Although the relationship between currency changes and inflation has weakened significantly since 2011, a stronger (as opposed to weaker) rand, is nonetheless welcomed by bond investors. Of course, the other side of sustained rand strength is reduced export competitiveness and cheapening imports - the proverbial double-edged sword with respect to the external account.

Figure 3: Rand closing in on our estimate of its inflation-adjusted fair value 
(USD/ZAR exchange rate versus its estimated purchasing power parity)

Source: Bloomberg, Futuregrowth

Other key South African economic data releases are mixed 

April private sector credit extension contracted by 1.8% year on year. Base effects also played a role in this, where a spike in the credit uptake of the South African corporate sector’s credit around the implementation of the national lockdown a year ago created a high base. The year-on-year M3 money supply growth rate increased by a mere 2.0%. In April, another significant surplus of R51.2 billion was recorded for the merchandise trade account, mainly the result of continued robust export performance. This bodes well for a sustained strong current account balance and currency stability. In contrast, the April budget balance surprised with a much wider than expected budget deficit of R80 billion, which is markedly higher than the 5-year average of R44 billion. This was mainly due to a staggering expenditure increase of 45.2% when compared to the same period last year, resulting from base effects, with higher-than-usual departmental expenditure (specifically by the Department of Higher Education and Department of Public Enterprises) also playing a role. While the robust recovery in revenue collections continues (relative to expenditure) revenue increased at a slower pace of 23.8% year on year. With only a month’s data available, it is difficult to make inferences on the state of the fiscus for the 2021/22 fiscal year, but our base case remains for some recovery from last year, driven largely by base effects. However, we remain cognisant of the mounting expenditure pressure which remains a threat to an already deteriorating fiscal position.

Nominal bond market returns surpassed those of inflation-linked bonds
and cash during April

The improvement in global investor sentiment and the other developments described above enabled nominal bond yields to drift lower for a second consecutive month. In the process, the market managed to regain more of the lost ground caused by the global mini-taper tantrum earlier this year. During May, the FTSE JSE All Bond Index (ALBI) rendered a strong return of 3.73%, with the biggest positive contribution from longer-dated bonds in the 12+ year maturity band as the yield curve flattened.

Inflation-linked bond yields also continued to drift lower, owing to sustained inflation-hedging demand in response to the inflation surge of late. As a result, the FTSE JSE Government Inflation-linked Index (IGOV) rendered a return of 3.42%, only slightly lower than that of the ALBI. The combination of reasonable valuation and expectations of higher inflation in the near term (which will boost the inflation carry offered by these bonds with a time lag of three months) served as a catalyst for sustained interest in this asset class. The performances rendered by both nominal and inflation-linked bonds were well above the 0.29% offered by cash during this period.

Figure 4: Bond market index returns (periods ending 31 May 2021)

Source: JSE, Futuregrowth


The sharp yield increase in major global bond markets (particularly the US) in the first quarter was backed by improved economic growth prospects, fears of higher inflation, and, by implication, future monetary policy tightening. This overdue sharp upward correction in developed market bond yields lost momentum in April and May as inflation concerns were played down by monetary policymakers, including the US Federal Reserve. Locally, extremely bearish rate expectations were also tempered by a strong, consistent message by the SARB, insisting that the upcoming inflation spikes are deemed transitory, which, together with a sustained negative output gap, imply no immediate impact on its policy rate. Some improvement in economic growth, the external account, and particularly the fiscal situation, convinced international rating agencies to hold back on rating action even though all expressed concern about the longer-term outlook. Improved risk appetite supported local markets for the second consecutive month. As a result, nominal and inflation-linked bond returns outperformed cash by a significant margin in May.


Key economic indicators and forecasts (annual averages)


    2017 2018 2019 2020 2021 2022
Gobal GDP   3.4% 3.3% 2.6% -3.6% 6.7% 4.6%
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% 2.0% -5.0%

Source: Old Mutual Investment Group