More central banks turn their backs on easier monetary policy conditions
The global supply chain remains strained: a textbook example of the downside risk to global interconnectivity, which, for over three decades allowed for more efficient allocation of global production factors. The persistent supply constraints contributed to upward price pressures, which are lasting longer than initially anticipated. As a result, the word “transitory” is now used more sparingly when it comes to the expression of inflation views, both by market participants and central banks. In a number of emerging markets, the resultant longer-lasting spike in inflation forced central banks to respond. Monetary policy tightening is also gaining traction in advanced economies, though at a more pedestrian pace. In stark contrast, the upside-down response by the Turkish central bank, as it cut rates by a further 200 basis points (bps) in the face of sky-high inflation (which has averaged 17% over the past calendar year) offers a textbook example of macro policy mismanagement as a result of political interference.
Figure 1: Central bank policy rate changes versus inflation
Source: Bloomberg, Futuregrowth
Bond markets respond to rising inflation concerns
The rising inflation concerns also forced financial markets to look for an earlier and more aggressive monetary policy response. This is reflected by faster-rising bond yields in the majority of advanced and emerging economies. The sharp increase of US Treasury yields in October (with two year-yields almost doubling to 0.5%) is particularly noteworthy as it anticipates the taper of the long-awaited and well-telegraphed US Federal Reserve’s USD120 billion a month bond-buying programme. While inflation may have surprised with its persistent elevated levels, poor bond market valuation was a sure sign that yields only have one way to go: upwards. This is less obvious in the case of the majority of countries in the emerging market group, where the general level of bond yields appears to reflect less complacency - both in terms of inflation and monetary policy expectations - while valuation relative to global reference rates seem reasonable.
Recent worse-than-expected inflation prints might turn the remaining SARB doves
While the members of the Monetary Policy Committee of the South African Reserve Bank (SARB) unanimously voted in favour of no rate action at the September meeting, it is clear that the next change to the repo rate will be upwards. While the combination of a fragile economic recovery in the outer years, a relatively benign inflation outlook, and a stronger balance of payment position allows for some breathing space relative to South Africa’s emerging market peer group, the recent higher-than-expected September producer price index (PPI) inflation print could spark an earlier start to the tightening cycle. PPI inflation for final manufactured goods accelerated to 7.8% year on year from 7.2% year on year the previous month. While the longer-term correlation between the Consumer Price Index (CPI) and PPI at the total level is not particularly strong, inflation bears will focus on the stronger correlation in the sub-components. The stronger positive correlation between CPI for goods and PPI for final manufactured goods is admittedly a reason for concern. As a result, the Forward Rate Agreement (FRA) market continues to reflect more bearish expectations of an earlier start and a steep rise in the repo rate over the next 21 months.
The fiscal backdrop has improved – but this is not unexpected
The most recent public sector finance data continues to point to a significant improvement, particularly relative to the previous fiscal year which was battered by the pandemic-induced growth collapse and additional expenditure pressures. However, this is mainly backward looking, as the recent sharp weakening in the country’s terms of trade as a result of commodity market gyrations is particularly concerning. Not only did commodity weakness (along with a stronger US Dollar) contribute to significant rand depreciation, it also had negative consequences for general economic activity and the fiscal position, both of which remain particularly fragile. In the absence of a non-energy commodity price recovery - which seems unlikely at this stage - the extent of the upside surprise to company tax revenue receipts in the first six months of the 2021/22 fiscal year will not be repeated. It follows that, unless current government expenditure is reduced and structural economic growth is sustainably improved, the outlook for faster fiscal consolidation has once again become murkier, which may only be clearly reflected in the 2022/23 fiscal year.
Figure 2: The earlier boost to company tax revenue is at risk in light of recent commodity gyrations
Source: Bloomberg, Futuregrowth
Nominal bonds continued their recent poor run
The developments described above contributed to significant market weakness during October. In addition to a general uptick in bond yields, changes to the yield curve reflected expectations of imminent monetary policy tightening, as the yields of shorter-dated bonds increased by more than those of ultra-long-dated bonds. As a result, bonds in the 3- to 7-year maturity band of the FTSE JSE All Bond Index (ALBI) rendered a return of -1.54%, with bonds in the 12+ year maturity band doing slightly better by returning 0.43%. At total index level, the ALBI’s return of -0.48% was significantly worse than the 0.29% offered by cash. In contrast to nominal bonds, inflation-linked bond yields edged lower while investors continued to benefit from a reasonable inflation carry. As a result, the FTSE JSE Government Inflation-linked Index (IGOV) rendered a decent return of 0.63% for the month. This asset class also managed to retain its first position for the first ten months of this year, with the IGOV returning 10.60% compared to 4.87% and 2.91% for the ALBI and cash, respectively.
Figure 3: Bond market index returns (periods ending 31 October 2021)
Source: Bloomberg, Futuregrowth
// THE TAKEOUT
Risk appetite was negatively impacted by rising concerns about the persistence of inflationary pressure, hence the timing and strength of monetary policy response. While global bond yields headed higher in response to more hawkish expectations, commodity market gyrations and a stronger US Dollar contributed to significant rand depreciation. As a result, nominal bond yields drifted higher, with medium-dated bonds taking the brunt of the upward correction as the yield curve bear flattened in response to a sharp rise in short-dated US treasury yields and in anticipation of the possible earlier start of the local tightening cycle. Against this backdrop, inflation-linked bonds proved slightly more resilient and, as a result, managed to render a return stronger than that offered by nominal fixed-rate bonds and cash.