Real Rates and Fiscal Strain Drive Yields Higher

The real rate march gathers steam

Global real rates ascended to multi-year highs in September, with the 10-year US Treasury Inflation-Protected Security (TIPS) yield closing the quarter at 2.23. This marks a remarkable turnaround from the -1.10% real rate recorded in December 2021. Real rates have adjusted higher in recent months 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 economies and the destructive effects of an overtightening of monetary policy.

In contrast to the still buoyant economic growth outcomes in the US, macroeconomic growth indicators in China and central Europe underwhelmed in the quarter. This is despite gradual monetary policy stimulus in China, which has carried the promise of lending marginal support to the flagging economy but has, to date, proved ineffective at reviving credit growth and aggregate demand.

In addition to being caught in the crosscurrents of a divergent global backdrop, the local bond market has had to contend with domestic structural constraints. The primary domestic impediment to growth remains the electricity shortfall, with loadshedding a permanent feature throughout the quarter. Despite this, the release of the second quarter economic growth statistics confirmed increased resilience to the electricity supply deficit, with aggregate economic growth outperforming downcast expectations.

Figure 1: Global real rate rout spurs domestic bond yields on to higher levels

Source: IRESS, Futuregrowth

Domestic disinflation loses momentum

Headline and core consumer price inflation (CPI) reached cyclical lows in the quarter, with both slowing to 4.7% year-on- year in July. This marked the lowest headline CPI rate in 24 months and brought it within reach of the midpoint of the South African Reserve Bank’s 3% to 6% inflation target band. Both edged slightly higher to 4.8% in August, with the waning effect of fuel price disinflation beginning to take root. We expect this to remain a risk to the inflation outlook in the medium-term. Disinflationary domestic food prices, anchored services inflation and a muted inflation impulse from China will moderately counter some of the near-term inflation risk.

Inflation at the producer level also reached a cyclical low in the quarter, with producer price inflation (PPI) of final manufactured goods troughing at 2.7% year-on-year in July.

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: The domestic disinflation trend is losing momentum

Source: IRESS, Futuregrowth

A hawkish pause by the South African Reserve Bank

In a tightly split vote, the South African Reserve Bank (SARB) Monetary Policy Committee (MPC) voted to leave the repurchase rate unchanged at 8.25% at its September meeting, with three committee members voting for no change and two voting for a 25-basis point hike. The post-announcement commentary from the Governor and his MPC members was decidedly hawkish, highlighting upside inflation risk in the near-term and the continued data-dependence of forthcoming policy decisions. Notwithstanding the risks, 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 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 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.

Local economic activity paints a mixed picture in the quarter

The July real retail sale print confirmed the eighth consecutive month of year-on-year declines in the series. Similarly, year-on-year private sector credit extension slowed to 4.4% in August, marking a 17-month low. 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.

Having shown signs of resilience to the electricity supply constraint, mining production started the 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 third quarter.

Despite the persistent decline in annual electricity production, Eskom seems to have arrested the decline in the energy availability factor into the quarter-end. The recommissioning of generation units at Kusile, combined with the increased reliance on self-generation, evidenced by the soaring solar panel import volumes from China in particular, will significantly contribute to alleviating the energy supply challenges in the months ahead.

Fiscal execution risk rears its head

The fiscal year-to-date data shows mounting evidence of fiscal slippage relative to the estimates tabled by National Treasury in February. Our fiscal year-to-date tracker suggests that the main budget balance is R60 billion behind target for the 2023/24 fiscal year, equivalent to an estimated 0.9% of GDP.

Against a backdrop of constrained electricity production and fragile domestic growth, aggregate income tax receipts for the first five 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.

Figure 3: Emerging evidence of fiscal underperformance

Source: National Treasury, Futuregrowth

Elevated global real yields filter through to local rates

The combination of higher developed market real yields, sustained rand weakness, and increased evidence of fiscal underperformance put upward pressure on domestic sovereign bond yields in August and September. The liquid nominal bond market 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 quarterly return of -0.33%, 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 1.96% for the quarter, and the ALBI +12-year segment returning -1.59%. The IGOV Index, comprised of sovereign issued local currency ILBs, rendered a quarterly return of 0.75%%, while cash rendered a return of 2.01% for the quarter, the highest across the interest-bearing asset class.

Figure 4: Bond market index returns (periods ending 30 September 2023)

Source: IRESS, Futuregrowth

//THE TAKEOUT: Global real rates marched to new heights during the quarter, with the 10-year US Treasury Inflation-Protected Security (TIPS) yield closing the quarter at 2.23%. Domestic nominal bond rates 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 September, which, at 4.8%, is marginally away from the midpoint of the central bank’s inflation target band. Despite receding price pressures, 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, and we expect National Treasury to adjust to these realities when it tables the medium-term budget policy statement in November.