The last mile is the longest

Bond market fortunes hinge on the Fed Pivot

The fortunes of bond markets were heavily swayed by monetary policy dynamics in the first quarter of 2024. The Federal Open Market Committee (Fed) voted to retain a Fed Funds target range of 5.25% - 5.50% at their January and March policy meetings, supported by the resilience in US macroeconomic data and stickiness in inflation statistics, even if partially technical in nature. While the median Fed Dot Plot continues to price 75 basis points of cumulative interest rate cuts this year, market participants’ conviction on the timing and magnitude of interest rate cuts has waned, evidenced by the significant move higher in US forward rates on a year-to-date basis. We align with the view expressed by the Fed Dot Plot and expect a gradual and shallow cutting cycle to start around midyear, led by a softening labour market, moderating consumer spending and a depleting savings pool – but these policy moves will be highly data dependent.   

While also pushing back against imminent interest rate cut expectations, the European Central Bank Governing Council has 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, closed the chapter on unconventional monetary policy measures and negative interest rates by hiking the policy rate for the first time since 2007.

Figure 1: Citi Economic Surprise Index (US) vs 10-year US Treasury Rates (USGB10)

Source: Bloomberg, Futuregrowth

The inflation beast is still kicking

Domestic headline consumer price inflation (CPI) maintained its recent upward trajectory in February, accelerating to 5.6% year on year in February from 5.3% in January. The negative impulse was primarily led by higher fuel inflation, amid dissipating base effects, and increased core price pressures. Producer Price Inflation, which measures inflation on final manufactured goods, grew by a more moderate 4.5% year on year in February. 

We assess the medium-term forecast risk to headline inflation to be to the upside, due primarily to the El Niño weather pattern and the related low rainfall in February, dampening expectations for this season’s agricultural production. Core inflation, which had remained fairly contained in recent months, increased to 5.0% year on year in February from 4.6% in January. The acceleration was primarily due to elevated medical aid tariffs. This price momentum diverges from fairy contained core inflation in recent quarters and contributed to a continually hawkish policy stance by the South African Reserve Bank (SARB) Monetary Policy Committee (MPC) at its March policy meeting, despite the already elevated real rate environment. 

The hurdle to domestic interest rate cuts will remain high in our assessment, with the timing and magnitude of cuts being highly data dependent. We expect easing global price pressures towards target levels, combined with the underlying weakness in consumer demand to nonetheless support the start of a shallow and very gradual interest rate cutting cycle in the second half of 2024.

Figure 2: RSA Forward Rate Agreement (FRA) Rates

Source: Bloomberg, Futuregrowth

High frequency macro data paints a mixed picture

Mining production, which was surprising resilient in the in the fourth quarter of 2023, contracted by 3.3% in January. This contraction is primarily attributable to electricity production and freight rail related constraints and marks a return to the general malaise in the performance of the sector in recent years. Manufacturing production grew at a slightly firmer 2.6% year on year in January, led by strong growth in petroleum and chemical production. 

January wrapped up the peak summer months for the local tourism sector and marked another month of gains for an industry which is yet to fully return to its pre-COVID activity levels. Domestic tourist arrivals grew by 18.3% year on year in January, and tourist accommodation, measured as the number of nights sold, grew by 9.5% year on year. 

Monthly private sector credit extension broadly drifted sideways in February, growing at 3.3% year on year relative to 3.2% in January. Generally, domestic credit trends remain weak, reflective of tight monetary conditions. 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 the second half of 2024.

SARS flies the flag for institutional reform

National Treasury tabled a credible budget in February, suitably striking the balance between debt containment and social support. Government finances 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). 

National Treasury’s anchor for debt stablisation remains 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 do this through a combination of expenditure constraint and marginal revenue upside, relative to the estimates published in the medium-term budget policy statement. 

Positively, the recent announcement by the President that the tenure of South African Revenue Service (SARS) Commissioner Edward Kieswetter had been extended by two years was only supplanted by the R10 billion overcollection in fiscal revenue receipts for the 2023/24 fiscal year relative to the estimates tabled by the National Treasury at the medium-term budget only a month earlier.  

Figure 3: The primary balance is a key anchor for debt stabilisation

Source: National Treasury, Futuregrowth

The “higher for longer” theme prevails in domestic rates

The domestic nominal yield curve bear steepened in the quarter, driven by the reinvigoration of the “higher for longer” theme that took hold in the global interest rate environment during the quarter. ALBI 1-3 was the best performing segment of the nominal bond curve, rendering a total return of 0.81% for the quarter relative to the ALBI total return of -1.80%. Cash, proxied by the STeFI Call Deposit Index, was the best performing interest-bearing asset class, returning 1.99% for the quarter, with the IGOV Index, comprised of sovereign issued local currency inflation-linked bonds (ILBs), rendering a quarterly return of -0.47%.

Figure 4: Bond market index returns (periods ending 31 March 2024)

Source: IRESS, Futuregrowth

/// THE TAKEOUT: The fortunes of bond markets were heavily swayed by monetary policy dynamics in the first quarter. While the median Fed Dot Plot continues to price 75 basis points of cumulative interest rate cuts this year, market participants’ conviction on the timing and magnitude of interest rate cuts has waned. We align with the view expressed by the Fed Dot Plot and expect a gradual and shallow cutting cycle to start around midyear, led by a softening labour market, moderating consumer spending and a depleting savings pool – but these policy moves will be highly data dependent. Domestic headline consumer price inflation maintained its recent upward trajectory in February, accelerating to 5.6% year on year in February from 5.3% in January. We assess the medium-term forecast risk to headline inflation to the upside, due primarily to the El Niño weather pattern and the related low rainfall in February, dampening expectations for this season’s agricultural production. 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.