Monetary Policy Committee holds as inflation rises


At the start of the year, many investors braced themselves for US yields to rise as the Great Rotation of bonds to equities gathered momentum, and as the Federal Reserve (Fed) eased up on extraordinary monetary stimulus.

Bonds rally and outperform equities even as the Fed tapers
Against expectations, US yields have fallen even as the Fed has reduced monthly bond buying to US$55 billion from US$85 billion. Last week, the 10-year Treasury yield benchmark fell to 2.5% from 2.9% at the beginning of the year. Several factors are likely at play: investors now believe that the Fed is in no hurry to hike rates, despite tapering. It also appears that investors are still concerned that the US economy will not regain its lost vigour, or perhaps with the S&P 500 near record highs, they are piling into bonds out of fear. Another argument is that many institutional investors are actually forced to buy more bonds when bond yields fall, since they have to match long-term liabilities. Still, another argument is that investors who were betting against bonds now have to 'short cover' and buy bonds at any price to protect their portfolios. All of these factors have led to bonds outperforming equities in the US so far in 2014. However, equities still offer better value for investors than bonds.

High-yielding US corporate bonds have also been in vogue. The effective yield of the Bank of America (BofA) Merrill Lynch High Yield Index fell to 5.5% its lowest level in 12 months and lower than the average of the 2003 - 2007 boom years. This yield is also barely above the longer-term default rate of 4.5% on these so called 'junk bonds'. On average, and over time, 4.5% of a corporate bond portfolio is unlikely to make interest payments in a given year and the yield should compensate the investor for this risk. Current investors are therefore either very optimistic that companies won't default on their debt or they are desperate for extra yield, given the low risk free yields available.

PIIGS bonds flying

European yields have taken a nosedive. Since mid-2012, fears of a disorderly break-up of the Eurozone have faded and Portuguese, Italian, Irish, Greek and Spanish yields have plunged, providing investors in these bonds very generous returns. Yields on safe-haven German bunds (bonds) are also well below those offered by US Treasuries.

More recently, the falling yields could be in anticipation of the European Central Bank (ECB) cutting interest rates further (already at 0.25%) or embarking on a quantitative easing programme similar to the Fed's. The Eurozone's inflation of 0.7% is simply too low and is way off the ECB's target of just below 2%. Moreover, the strong Euro is holding back the Eurozone's recovery - the economy only grew by 0.2% quarter-on-quarter in the first quarter. Though yields on Spanish and Italian bonds kicked up a bit last week, they remain at record-low levels, and the market might be overly optimistic given that both countries still have large debt problems.

Carry trade alive and well again

Emerging markets - especially the Fragile Five countries dependent on foreign funding - bore the brunt as capital flows to emerging markets dried up and reversed from May last year to early this year. The Rand plunged to R11.40/US$ and the SA Reserve Bank (SARB) followed its peers in hiking interest rates despite a weak economy. But the Fragile Five countries can now possibly claim that they no longer deserve that label. Bond yields in all five countries are trading below 2014 peaks, and their currencies have strengthened (and emerging market equities are now ahead of developed market equities year-to-date).

In South Africa's case, the Rand strengthened to around R10.40 and the10-year government bond yield fell from 8.7% in late January to 7.9%. This reflects a more benign local inflation outlook compared to January, but also that falling yields elsewhere have made our bonds more attractive and therefore attracted foreign interest. Net foreign purchases of bonds are now R7 billion year-to-date, a significant turnaround compared to earlier in the year. The All Bond Index has returned 3% year-to-date, ahead of cash, with longer dated bonds giving investors a return of more than 4% year-to-date.

Monetary policy committee holds as inflation rises

The SARB's Monetary Policy Committee (MPC) left the repo rate unchanged at 5.5% last week. While this was the expected outcome, it was nonetheless a difficult decision. Data released last week showed that headline consumer inflation had breached the 3% - 6% target range in April, rising to 6.1% from 6% in March. The main contributor was higher food inflation, increasing by 7.8% on an annual basis, up from 7% in March. The weaker Rand and rapidly rising global food prices is expected to continue filtering through to local food inflation. However, local maize prices fell sharply over the past month, which will take some pressure off food inflation.

 Inflation in line with expectations

While headline inflation rose, core inflation which excludes the impact of volatile food and energy prices remained unchanged at 5.5%. Core inflation gives a better picture of underlying inflation trends, and shows that the 'second round' effect of a weak Rand, i.e. the extent to which firms passed on their currency-driven cost increases to consumers has been limited. However, the MPC noted that this current low level of pass-through from the exchange rate inflation could increase. And while the Rand has improved over the past two months, the large current account deficit means it remains vulnerable to depreciation.

The MPC's statement noted that April's inflation numbers were in line with their forecast at the time of the March meeting (which also resulted in no change to the repo rate). Inflation is expected to average slightly lower at 6.2% in 2014 (the previous forecast was 6.3%) peaking at 6.5% (previously 6.6%) in the fourth quarter. Inflation is expected to average 5.8% in 2015, moving within the target range in the second quarter of next year.

Local economy deteriorating

The local economic outlook, according to the MPC had "deteriorated markedly", is a contributing factor for keeping rates on hold. Mining and manufacturing contracted in the first quarter, while consumer spending slowed significantly and unemployment rose. The SARB's 2014 forecast for economic growth has been downwardly revised from 2.6% to 2.1%. The forecast for 2015 remains unchanged at 3.1%. This means that a large and persistent output gap - the difference between the economy's actual and potential growth rates - should continue to have a moderating impact on inflation pressures.

The fact that the risks to the inflation outlook are to the upside, while growth could disappoint further means the MPC continues to face a dilemma. The MPC reiterated that we are in a rising interest rate cycle, but it could be a while before the next hike is made.

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Issue 72