Domestic bonds buck the real rate trend

Global real rates march higher

Global real rates continued their steep ascent in October, with the 10-year US Treasury Inflation-Protection Security (TIPS) yield marching to a month-end closing yield of 2.52%. Nominal rates in the US followed suit, leaving inflation-breakeven rates largely unchanged during the month. This marks a remarkable turnaround from the negative interest rate environment of a few years ago, with bonds yielding negative interest rates virtually wiped out from the cumulative global peak of $17.2 trillion.

The surge in developed market interest rates is largely attributable to the evolution in inflation and monetary policy dynamics in recent years, but it would be neglectful to overlook growing risk of loose fiscal policy in the developed market policy mix. Specifically, the ultra-loose fiscal policy stance in the US has raised concerns about its ballooning sovereign debt stock and increased long-term debt issuance – all while the Federal Reserve and other major central banks remain committed to consolidating their balance sheets and significant foreign buying interest from China wanes. The approaching US presidential election and growing risk of an economic growth slowdown in 2024 raise the odds that fiscal policy will not be meaningfully recalibrated in the near term, with eroding fiscal dynamics remaining a market watchpoint in the medium term.

The local bond market largely shrugged off these market forces in October, with long-dated nominal bonds retreating from the sharp sell-off to 13% in September. Inflation breakeven rates also retreated, adjusting to both lower nominal yields and increasing inflation-linked bond yields during the month.

Figure 1: 10-year constant maturity US real and nominal yields

Source: IRESS, Futuregrowth

Domestic inflation bounced up from the cyclical trough

Headline consumer price inflation (CPI) spiked to 5.4% year-on-year in September from 4.8% in August, primarily due to higher fuel prices and rand weakness on a year-on-year basis. These factors will remain the predominant risk to the domestic headline CPI outlook in the medium term, with continued spillover risk from the ongoing Israel/Palestine conflict to the broader Middle East region. Despite this threat to headline inflation, the moderation in core CPI in September, largely due to a slow-down in rental inflation to 2.6% year-on-year, clearly reflects the weak underlying demand-pull pressure on inflation.

While the South African Reserve Bank (SARB) monetary policy committee (MPC) remains decidedly hawkish, justified in part by inflation expectations which remain anchored above the mid-point of the 3% to 6% inflation target band, the underlying detail in recent inflation reports continues to point to weak underlying price pressure at a consumer level. Notwithstanding the risks, particularly those posed by loadshedding, fuel price hikes, and sustained rand depreciation, we expect a prolonged pause in domestic interest rates before a gradual cutting cycle commences towards the middle of 2024.

The combination of a hawkish MPC (unlikely to cut interest rates quickly or materially) and relatively sticky headline consumer price inflation above the midpoint of the inflation target band in the months ahead will contribute to an elevated and thus restrictive real monetary policy rate in the medium term.

Inflation at the producer level also continues to edge higher from the recent 2.7% cyclical trough in year-on-year producer price inflation (PPI) of final manufactured goods. PPI increased by 5.1% on a year-on-year basis in September, also driven higher by fuel prices.

Figure 2: Domestic inflation has bounced up from the cyclical trough

Source: IRESS, Futuregrowth

Weak underlying economic activity persists

Real retail sales contracted by -1.2% year-on-year in August, marking the ninth consecutive month of year-on-year declines. The monthly private sector credit extension data for September also continues to show softness in credit lending to households and corporates. The underperformance in these indicators points to the strain placed on consumer discretionary spending by the combination of loadshedding and the prolonged monetary policy tightening cycle. While these data points haven’t been key determinants of monetary policy decision making in this cycle, they continue to highlight the weakness of aggregate demand in the domestic economy and will lend support to the arguments of the monetary policy doves in 2024.

Having shown signs of resilience to the electricity supply constraint, mining production started the third quarter on the back foot. Pleasingly, the manufacturing sector continues to circumnavigate the challenging circumstances, stringing along a series of positive annual growth rates throughout the quarter.

Despite the persistent decline in annual electricity production, with the 6.4% year-on-year drop in August extending a 24-month unbroken streak in output declines, Eskom seems to be arresting the declining energy availability factor of its generation plants. While loadshedding is likely to remain a facet of local life in the coming years, the recommissioning of generation units at Kusile, combined with the increased reliance on self-generation, will significantly contribute to containing some of the energy supply challenges in the months ahead.

Fiscal execution risk is realised

The tabling of the Medium-Term Budget Policy Statement (MTBPS) confirmed the slippage in fiscal estimates relative to those tabled by National Treasury in February. Specifically, on account of the triple threat of weak nominal gross domestic product, expenditure overruns and revenue underperformance, the main budget deficit is expected to slip to -4.7% in the 2023/24 fiscal year, relative to the -3.9% expected in the February budget. National Treasury forecast that gross loan debt-to-GDP will again peak higher and later than previously envisioned, this time at 77.7% in 2025/26.

While these updated fiscal estimates now better reflect our own assessment of the likely fiscal path, the risk remains for further slippage in the outer years of the medium-term expenditure framework (MTEF). Moreover, we remain particularly concerned by the high debt service costs and their consequent crowding-out effect on growth-enhancing expenditure, and the spiraling demands of mismanaged state-owned enterprises (SOEs) on the fiscus.

Figure 3: 2023 MTBPS relative to the February Budget

Source: National Treasury, Futuregrowth

Nominal bonds shine in October

Despite increased developed market yields in October, domestic nominal yields edged marginally lower, unwinding some of the capital losses incurred in September. The ALBI Index rendered a monthly return of 1.71%, outperforming the broader interest-bearing asset class. ALBI +12 years was the best performing subsector, returning 1.99%. The IGOV Index, comprised of sovereign issued local currency Inflation-linked bonds (ILBs), was the worst performing interest-bearing sector in the month, rendering a return of -1.01%. Cash, proxied by the SteFI Composite Index, rendered a monthly return of 0.67% in October.

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

Source: IRESS, Futuregrowth

/// THE TAKEOUT: Global real rates marched to new heights in October, with the 10-year US Treasury Inflation-Protected Security (TIPS) yield closing the month at 2.52%. Global nominal bond yields followed suit. Despite the unfavourable global backdrop and domestic fiscal strain, domestic nominal yields retreated in the month. Domestic inflation, at both a consumer and producer level, troughed in the third quarter and has edged up in recent months, largely due to increasing fuel prices and currency weakness on a year-on-year basis. Against this backdrop, the SARB MPC remains decidedly hawkish and 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 follow. From a government finance perspective, expenditure pressure and slowing corporate income tax receipts have contributed to the underperformance of fiscal metrics. While the MTBPS accounted for these realities, we believe the extent of fiscal slippage is still underestimated in the outer years of the MTEF.