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A few silver linings…

31 Jan 2021

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

Economic & bond market review

The Federal Reserve sticks to its well-telegraphed message

With the ever-present COVID-19 pandemic still casting a dark shadow in most parts of the world, the Federal Reserve (the most influential global central bank) emphatically repeated, in its latest monetary policy statement, its commitment to achieving maximum employment - and this at an inflation rate moderately above 2%.

Not only will the Federal Reserve maintain its policy rate at the current level for as long as it takes, but will keep increasing its already large holding of US Treasury and agency mortgage-backed securities in an effort to smooth out market functioning, and thus continue to lend both direct and indirect support to a fragile US economy. It once again snuffed out any market thoughts of a repeat of the 2013 taper tantrum.

While this stance is understandably welcomed by markets in general, the combination of unprecedented low interest rates and the growing size of the central bank’s balance sheet will spook inflation hawks.

Improved risk appetite by local and foreign bond investors alike

In the case of South Africa, the statement by the Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB) following its most recent meeting seemed a touch less dovish - even though the repo rate was left at 3.5% after the third consecutive 3/2 split decision.

Even so, this was aligned with general expectations. Market participants focused on pandemic and related vaccine developments, which, amidst sustained unusual levels of liquidity, continued to boost global risk appetite.

A string of positive local data releases also served to boost sentiment. Investors, sensing that the local bond market offers some value at current elevated levels (especially considering the steep yield curve slopes and strong consensus that monetary policy will remain expansionary for an extended period) became keen buyers of both nominal and inflation-linked bonds. In the case of nominal bonds, foreign investors invested around R6 billion in January.

Strong investor demand leads to a solid start to the new year

The nominal bond yield curve bear flattened during the month as yields rose at the shorter end. This was primarily due to rate cut expectations being priced out as the MPC kept rates on hold. The R5 billion switch auction of the shorter R2023 bond into longer-dated bonds during the period also played a role in driving the bear flattening.

In contrast, inflation-linked bonds rallied across the real yield curve owing to stronger demand, which caused the real yield curve to bull flatten. As a result, inflation-linked bonds, and to a less extent, nominal bonds had a strong start to the year. The FTSE JSE All Bond Index (ALBI) returned 0.71%, with ultra-long-dated nominal bonds taking the lead on the basis of strong base accrual. In the case of inflation-linked bonds, the FTSE JSE Government Inflation-linked Index (IGOV) rendered a very strong return of 2.04%. 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 catalyst for renewed interest in this asset class. Both indices delivered returns well in excess of the 0.29% rendered by cash for the month.

Figure 1: Nominal Bond Yield Curve changes during January 2021

Nominal Bond Yield Curve changes during January 2021
Source: National Treasury, Futuregrowth

Local data releases in January were mostly encouraging

The rate of inflation at both consumer and producer levels remained relatively benign in December - despite the confirmation of faster rising food prices which continue to put upward pressure on inflation. The Headline Consumer Price Index (CPI) accelerated by 3.1% year-on-year, a touch lower than the previous month’s 3.2%, while Core CPI was also stable at 3.2%. December Producer Price Index (PPI) data revealed similar levels.

The positive flow on the external trade account continued as the December balance of +R32 billion turned out to be the eighth consecutive monthly goods trade surplus. This, in turn, points to a possible (welcome) current account surplus for the 2020 calendar year. December fiscal data also brought about positive news as strong tax revenue receipts point to a much-needed revenue over run relative to the October Medium Term Budget Policy budget estimates. This, together with slightly lower expenditure, is expected to give rise to a lower budget deficit and thus smaller future funding requirement. While this news served as a catalyst for improved investor sentiment, enthusiasm needs to be curbed by the reminder that both the broader economic backdrop and the fiscal situation remains dire. Bold policy measures are still required to rectify significant imbalances. 

Figure 2: Bond market returns (periods ending 31 January 2021)

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

// THE TAKEOUT

Although inflation is slowly regaining positive momentum, strong disinflationary forces are still at play. Even so, a cautious central bank again opted to keep the repo rate unchanged at the most recent MPC meeting, following a series of unprecedented cuts totalling 300 basis points last year that left the repo rate at an all-time low of 3.50%. While economic activity picked up significantly in the third quarter - following the devastating impact of the national lockdown in the second quarter - economic activity appears to be losing momentum of late. Even though tax revenue receipts have recently surprised on the upside, the weak economic backdrop does not bode well for a fiscal situation that is still at its most fragile in many years. This unfortunately supports our scepticism about government’s ambitious expenditure reduction plan. The combination of stable monetary policy and a slippery fiscal path implies an anchored short end, with upside risks to the yields of longer-dated nominal and inflation-linked instruments.

Key economic indicators and forecasts (annual averages)

 

    2017 2018 2019 2020 2021 2022
Gobal GDP   3.4% 3.3% 2.6% -3.6% 5.7% 4.7%
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% 2.0% -0.5.0% -1.5%

Source: Old Mutual Investment Group