Bond markets looked to the Fed for guidance

Economic surprises buoy market rates

Bond markets hung on the words of Federal Reserve Speakers for forward guidance on US monetary policy in February. Resilience in US macroeconomic data and stickiness in inflation statistics, even if partially technical in nature, has arrested market expectations of an imminent interest rate cutting cycle. The US forward rate market now aligns better to the latest Fed Dot Plot, published in December 2023, which prices a median Fed Funds Rate of 4.63% for 2024 and continually gradual interest rate cuts into 2025. We’re aligned to this view and expect a gradual and shallow cutting cycle to commence towards midyear, led by a softening labour market, moderating consumer spending and a depleting savings pool – but these policy moves will be highly data/state dependent.

While also pushing back against imminent interest rate cut expectations, Christine Lagarde and her ECB Governing Council colleagues have an altogether finer balance to strike between still elevated inflation outcomes and weak aggregate economic growth conditions. Here too, the timing of the interest rate cutting cycle remains highly data dependent, but the hurdle to policy action is lower, in our estimation. The Bank of Japan, on the other hand, edges closer to closing the chapter on negative interest rates and hiking its policy rate for the first time since 2007.

Figure 1: Citi Economic Surprise Index (US) vs USGB10

Source: Bloomberg, Futuregrowth

Sticky consumer price pressures persist

Domestic headline consumer price inflation (CPI) rose to 5.3% year on year in January from 5.1% in December. The acceleration was led by higher fuel inflation, amid dissipating base effects, and moderately increased core price pressures. Domestic inflation on final manufactured goods held steady at 4.7% in January.

We assess the medium-term forecast risk to headline inflation to the upside, due primarily to the forecast El Niño weather pattern and its bearing on the domestic agriculture harvest. While core inflation rose to 4.6% year on year from 4.5% in December, this component of the consumer basket nonetheless remains fairly contained and continues to reflect the weak underlying demand-pull pressure on inflation.

Elevated and sticky consumer price inflation expectations, anchored above the midpoint of the South African Reserve Bank’s (SARB’s) 4.5% midpoint of the inflation target band support a continually hawkish policy stance by the Monetary Policy Committee (MPC). Although the domestic real policy rate is elevated, the hurdle to domestic interest rate cuts will remain high in our assessment, with the timing and magnitude of cuts being highly data dependent. Easing global and domestic price pressures towards target levels, combined with the underlying weakness in consumer demand will nonetheless support the commencement of a shallow and very gradual interest rate cutting cycle around the middle of 2024.

Figure 2: South Africa’s Real Policy Rate

Source: Bloomberg, Futuregrowth

High frequency economic data flatters to deceive

Mining production, which flattered to deceive in recent months, plummeted to 0.57% year on year in December. This marks a sharp descent from the 6.77% recorded in November – and a return to the general malaise in the performance of the sector in recent years. Manufacturing production also remains sluggish, although less volatile, growing at 0.7% year on year in December.

The South Africa Electricity Production Index grew by 0.8% in January from 4.4% in December. While only growing moderately, it represents a pleasant turn from the deep production cuts in recent years. This measure also does not account for private sector electricity production in the form of rooftop solar and related private electricity generation, which has contributed to easing the loadshedding burden.

Monthly private sector credit extension slowed to 3.2% year on year in January, from 4.9% in December. This acceleration in credit lending was influenced by the decline in household credit lending and the sharp decline in loans and advances to the corporate sector. Credit lending standards have not been key determinants of monetary policy in the current hiking cycle, but they nonetheless highlight the weakness of aggregated demand (particularly for households) and will lend support to the arguments for monetary policy easing in 2024.

GFECRA improves the medium-term debt profile

National Treasury tabled a positive yet credible budget, which significantly benefited from the use of South Africa’s Gold and Foreign Exchange Reserve Account (GFECRA) to help stabilise debt issuance and the sovereign debt/GDP profile over the medium-term expenditure framework (MTEF).

An anchor for debt stabilisation from a policy perspective is achieving a primary budget surplus, which is measured as the difference between fiscal revenue receipts relative to non-interest expenditure. National Treasury expects to achieve a primary surplus in the current fiscal year and throughout the MTEF. It plans to achieve this through a combination of expenditure constraint, with main budget expenditure receding from 29% relative to GDP in the 2023/24 fiscal year to 28.2% in 2026/27, and marginal revenue upside relative to the estimates published in the medium-term budget policy statement.

Positively, no additional expenditure was allocated to State Owned Enterprises (SOEs) in the 2024 budget. Transnet will be limited to a R47 billion government guarantee with no mention of an equity injection. The guarantee is to address persistent challenges relating to liquidity and supply chain backlogs. Of the R78 billion allocated to Eskom in 2023/24, R44 billion has been provided, with R16 billion to be converted to equity subject to conditionality.

National Treasury’s near-term budget estimates broadly align with our own expectations, but significant execution risk remains in the outer years of the MTEF. Moreover, GFECRA presents a once off, ‘non-core’ boost to government finances. In our estimation, in addition to National Treasury remaining committed to abiding by its fiscal anchors, macroeconomic growth greater than 2.5% year on year remains a necessary precondition to sustainably addressing South Africa’s fiscal challenges.

Figure 3: Main Budget Framework

Source: National Treasury, Futuregrowth

“Higher for longer” drives the bear flattening of yields

The domestic nominal yield curve bear flattened in February, continually driven by the “higher for longer” theme by international and domestic market participants. ALBI 1-3 was the best performing segment of the nominal bond curve, rendering a total return of

-0.04% for the month relative to the ALBI total return of -0.58%. Cash, proxied by the STeFI Call Deposit Index, was the best performing interest-bearing asset class, returning 0.63% for the month, with the IGOV Index, comprised of sovereign issued local currency inflation-linked bonds (ILBs), rendering a monthly return of -0.77%.

Figure 4: Bond market index returns (periods ending 29 February 2024)

Source: IRESS, Futuregrowth

/// THE TAKEOUT: Bond markets hung on the words of Federal Reserve Speakers for forward guidance on US monetary policy in February. Resilience in US macroeconomic data and stickiness in inflation statistics have arrested market expectations of an imminent interest rate cutting cycle. We still expect a gradual and shallow cutting cycle to commence towards midyear, led by a softening labour market, moderating consumer spending and a depleting savings pool – but these policy moves will be highly data/state dependent. Domestic headline consumer price inflation (CPI) rose to 5.3% year on year in January from 5.1% in December, remaining generally elevated and sticky above the increasingly explicit 4.5% SARB inflation target. However, inflation expectations remain sticky and elevated. Against this backdrop, the SARB MPC remains decidedly hawkish. We share the SARB’s concerns about the near-term risk to consumer prices but believe that the 8.25% repo rate marks the peak of the current interest rate cycle, with a cutting cycle to commence around mid-year. From a government finances perspective, National Treasury’s near-term budget estimates broadly align with our own expectations, but significant execution risk remains in the outer years of the MTEF.