The Fed pivot is on for 2024

The Federal Reserve Bank (Fed) Pivot is on for 2024. The post-COVID ascent in US interest rates was arrested by the dovish policy guidance that accompanied the Federal Open Market Committee (FOMC) policy decision in December. While holding the lower bound of the Fed Funds Rate steady at 5.25% in December, the FOMC voting members nonetheless marked a turning of the tide for the “Great Repricing” of developed market bonds by forecasting a cumulative 75 basis points of interest rate cuts in their “Dot Plot”.

It now seems likelier than ever that the Fed played its last act in the interest rate cycle when it hiked the lower bound of the Federal Funds Target Rate to 5.25% in July. In the Eurozone, weak underlying economic growth conditions and cooling price pressures also strongly suggest that the 25 basis point (bps) increase in the Deposit Facility Rate in September to 4.0% marked the last in a cumulative 450 bps interest rate hiking cycle.

Against this backdrop, the 10-year US Treasury Inflation-Protection Security (TIPS) yield retreated to a quarter-end closing yield of 1.71% from an intra-quarter peak of 2.22%. Nominal yields in the US followed suit, with the generic 10-year nominal bond rate closing the quarter at 3.88%, recovering from an intra-quarter peak of 4.99%. This bond market strength filtered through to the local rates, with the generic 10-year local currency bond yield retreating from 12.37% at the end of September to 11.37% at the end of the quarter.

Figure 1: Federal Reserve Bank Dot Plot

SARB policy stance will give way to a shallow cutting cycle

Headline consumer price inflation (CPI) retreated to 5.5% year on year in November from 5.9% in October. Food inflation remained elevated, with all but two food categories recording month-on-month price increases. Although the factors underpinning the price pressures are already easing, forecast risk remains to the upside due to the forecast El Niño weather pattern, continued irrigation challenges presented by unreliable electricity generation, and the avian influenza which has put significant upward pressure on poultry and poultry-related prices. Core inflation, on the other hand, remained muted at 4.5% year on year in November, reflecting the weak underlying demand-pull pressure on inflation.

Inflation at the producer level also slowed in November, with final manufactured goods inflation retreating to 4.6% year on year from 5.8% in October. Producer inflation was led lower by receding food prices and transport costs.

Stubbornly elevated inflation expectations, anchored above the midpoint of the South African Reserve Bank’s (SARB’s) 3% to 6% inflation target, will support a continued hawkish policy stance by the Monetary Policy Committee (MPC) in the forthcoming months – but easing global price pressures combined with the underlying weakness in domestic demand will support the commencement of a shallow interest rate cutting cycle towards the middle of 2024.

Figure 2: South Africa monetary policy expectations

Source: Bloomberg, Futuregrowth

High frequency data highlights macroeconomic vulnerability

Real retail sales contracted by 2.5% year on year in October. Aside from the modest growth in September, October’s contraction marked a return to a familiar pattern of year-on-year declines in the series – the tenth in the past twelve months. Real retail sales highlight the weakness in the domestic economy – particularly for consumer discretionary spending.

Monthly private sector credit extension slowed to 3.8% year on year in November from 3.9% in October, with the weakness in mortgage advances and household credit lending further highlighting the strain on consumer spending. These data prints 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.

Mining and manufacturing production both rebounded in October, growing 3.9% and 2.1% year on year, respectively, after contracting in September. Despite the monthly rebound, output in both sectors remains volatile and below pre-pandemic levels, hampered by both insufficient and unreliable electricity generation and acute Transnet-related logistics challenges.

Medium-term fiscal risks persist

Following the publishing of November’s fiscal metrics, year-to-date tracking relative to preceding years points to the risk of marginal fiscal slippage relative to the estimates tabled in the Medium-Term Budget Policy Statement (MTBPS), but are largely in line with our own expectations. Without improved economic growth, the risk of fiscal underperformance also threatens the outer years of the medium-term expenditure framework. We remain particularly concerned about the high debt service costs and their consequent crowding-out effect on growth-enhancing expenditure, as well as the spiraling demands of mismanaged state-owned enterprises (SOEs) on the fiscus.

Figure 3: Debt service costs and real gross domestic product (GDP)

Source: Bloomberg, Futuregrowth

Global rates lead the local bond market recovery

The domestic nominal yield curve bull steepened in December, with a growing consensus on the likelihood of interest rate cuts domestically and across the major developed markets in the first half of 2024. This followed a strong market rebound in November, where receding US real rates led domestic rates significantly lower, contributing to an extraordinary quarterly JSE ALBI Index return of 8.11%. Easing global interest rate expectations and real rates also spurred on the domestic real rate market, with the IGOV Index, comprised of sovereign issued local currency inflation-linked bonds (ILBs), rendering a quarterly return of 6.16%. Cash, proxied by the STeFI Call Deposit Index, was the worst performing interest-bearing sector in the quarter, rendering a return of 2.00%.

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

Source: IRESS, Futuregrowth

/// THE TAKEOUT: November marked a turning of the tide for the Great Repricing, with developed market bond yields retracting from their recent peaks. This strength filtered through to the local rates, with the generic 10-year local currency bond yield retreating from 12.37% at the end of September to 11.37% at the end of the fourth quarter. Domestically, despite weak economic conditions, domestic consumer prices continued to test the upper bound of the SARB target band in the quarter, largely due to increasing fuel and food prices on a year-on-year basis. Against this setting, 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 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 Medium Term Expenditure Framework (MTEF).