Caught in the crosshairs of policy divergence

Real rates march to new heights

Real rates marched to new heights in August, with the 10-year US Treasury Inflation-Protected Security (TIPS) yield closing the month at 1.85%. This marks a 14-year peak, and a remarkable turn from the -1.16% real rate recorded at the end of December 2021. Real rates in in the US and Euro area will remain positive to ward off elevated inflation expectations, with an increasingly fine balance to be struck by central bankers between the desired, but historically elusive, “soft-landing” of the economy and the destructive crash-landing scenario induced by an overtightening of monetary policy.

In contrast to the still buoyant economic growth and inflation outcomes in the US and central Europe, macroeconomic growth indicators in China underwhelmed in August, with year-on-year consumer prices threatening to follow producer prices into deflationary territory. Gradual policy stimulus will carry the promise of lending marginal support to the flagging economy but is likely to remain insufficient to meaningfully bolster aggregate growth and ward off the risk of debt deflation and a liquidity trap.

The local bond market has been caught in the crosshairs of this divergent macroeconomic backdrop, bearing the brunt of both elevated real rates, and a fragile growth and fiscal environment. Domestic growth concerns are largely structural, but underwhelming economic activity in China following the loosening of strict COVID-related lockdowns hasn’t provided the expected support to domestic exports and aggregate growth.

Figure 1: Central bank real (inflation-adjusted) policy rates

Source: National Treasury, Futuregrowth

The domestic disinflation trend gains momentum

Both headline and core consumer price inflation (CPI) surprised market expectations to the downside in July, slowing to 4.7% year on year. This marks the slowest headline CPI rate in 24 months, bringing it within a whisker of the 4.5% mid-point of the South Africa Reserve Bank’s 3 to 6% inflation target band. The slowdown in headline CPI was driven by easing food and fuel prices. While the disinflationary impact of fuel prices is likely to wane in the coming months, moderating domestic food and services inflation, as well as the disinflationary impulse from the Chinese economy, will all contribute to stemming domestic consumer price pressures.

Inflation at the producer level again surprised to the downside in July, with the prices of final manufactured goods at the producer level increasing by 2.7% year on year. This marks a significant turn from the cyclical peak of 18.0% recorded twelve months before. Fuel prices again provided the major disinflationary impetus – with this support likely to fade in the coming months as global crude oil prices adjust to production cuts by Russia and Saudi Arabia and the trade-weighted rand remains on the back foot.

Figure 2: Consumer and producer price inflation have rapidly rolled over

Source: IRESS, Futuregrowth 

A hawkish pause by the South African Reserve Bank

The downside surprise in both headline and consumer price inflation for July heightens our conviction that the May repo rate hike of 50 basis points (bps) by the South African Reserve Bank (SARB) Monetary Policy Committee (MPC) to 8.25% marked the last in the current cycle. Notwithstanding upside pressure in consumer prices in the near term, particularly those posed by loadshedding, fuel price hikes, and sustained rand depreciation, we now expect a prolonged pause in domestic interest rates before a gradual cutting cycle commences in the first half of 2024.

The moderation in domestic CPI towards the midpoint of the target band will limit the immediate room for further interest rate tightening by the MPC, but still-elevated inflation expectations in the US, Euro area and domestically, as surveyed by the Bureau for Economic Research (BER), will likely contribute to a continually hawkish MPC.

The combination of a hawkish MPC, unlikely to cut interest rates quickly or materially, and only marginal moderation in headline consumer price inflation in the months ahead will contribute to an elevated and thus restrictive real monetary policy rate in the medium-term.

Figure 3: The South African inflation-adjusted repo rate moved deeper into positive territory in August

Source: Bloomberg, Futuregrowth 

Local economic activity paints a mixed picture in August

The South African Electricity Production Index declined by 3.4% year on year in July, marking the 22nd consecutive month of electricity production declines, measured on a year-on-year basis. Despite the electricity deficit and consequent loadshedding intensity of varying degrees over this period, high frequency economic data continues to point to heightened economic resilience. Specifically, the year-on-year growth in mining and manufacturing production again exceeded consensus expectation in June, despite intensified loadshedding over this period.

While the mining and manufacturing sectors showed pleasing resilience to the fragile macroeconomic backdrop, year-on-year retail sales not only declined for a seventh consecutive month, but also continue to underwhelm relative to consensus expectations. This underperformance in retail sales suggests that consumer discretionary spend is under pressure, with the combination of loadshedding intensity and a prolonged monetary policy tightening cycle both taking their toll.

Positively, the labour intense tourism sector continues to recover, with foreign tourist arrivals recovering from their COVID lows. Freight volumes also continue to show signs of pleasing resilience and recovery to the generally challenging macroeconomic backdrop.

Expenditure pressure compounds revenue underperformance

The fiscal year-to-date data shows mounting evidence of fiscal slippage. Relative to the R275 billion main budget deficit that National Treasury tabled for 2023/24, our year-to-date fiscal tracker suggests that it is already R30 billion behind target, equivalent to an estimated 0.5% of GDP.

Against a backdrop of constrained electricity production and fragile domestic growth, aggregate income tax receipts for the first four months of the fiscal year to August have held-up reasonably well, but the combination of upside expenditure pressure and a smaller nominal GDP base are likely to contribute to deteriorated estimates when National Treasury tables its Medium-Term Budget Policy Statement in November, relative to the estimates tabled at the main Budget in 2023.

Elevated global real yields filter through to local rates

The combination of higher developed market real yields, sustained rand weakness, and early evidence of fiscal underperformance put upward pressure on domestic sovereign bond yields in August. The liquid, nominal bond market, with its dwindled but still significant 28% share of foreign ownership as a percentage of outstanding debt, remained highly responsive to the changing market conditions. Inflation-linked bond (ILB) yields, on the other hand, remained range-bound, resulting in a further widening of inflation break-even rates.

As a result, the ALBI index rendered a monthly return of -1.10%, underperforming the broader interest-bearing asset class. This aggregate reading belies the divergent sectoral split, with the ALBI 1 to 3-year maturity segment returning 0.91% for the month, and the ALBI +12-year segment returning -1.10%. The IGOV Index, comprised of sovereign issued local currency ILBs, rendered a monthly return of 0.42%, while cash rendered a return of 0.67% for the month, the highest across the interest-bearing asset class.

Figure 4: Bond market index returns (periods ending 31 August 2023)

Source: IRESS, Futuregrowth

THE TAKEOUT: Global real rates marched to new heights in August, with the 10-year US Treasury Inflation-Protected Security (TIPS) yield closing the month at 1.85%. Domestic nominal bond rates readily followed suit, increasing the break-even inflation rate priced into the sovereign bond market. Market-implied inflation rates are significantly divergent to year-on-year consumer price inflation for August, which, at 4.7%, is only a whisker away from the midpoint of the central bank’s inflation target band. Despite receding price pressures, the SARB MPC remains decidedly hawkish, and, so far, unwilling to openly concede that we are at the end of the monetary policy tightening cycle. We share the SARB’s concerns about the near-term upside risk to consumer prices but believe that the 8.25% repo rate marks the peak of the current interest rate cycle, with a prolonged pause to now follow. From a government-finances perspective, expenditure pressure and slowing corporate income tax receipts have contributed to the underperformance of fiscal metrics, and we expect National Treasury to adjust to these realities when it tables the medium-term budget policy statement in November.