A good Article from PSG Asset Management.
"In the fixed interest world, there are many variables which influence the yield on government bonds. The two most important, however, are the Consumer Price Index (CPI) - the broad basket measure of inflation - and the repo rate - which is set by the Monetary Policy Committee (MPC) of the South African Reserve Bank (SARB).
We rely heavily on the level and expected future path of inflation, as measured by CPI. This determines whether a nominal government bond is delivering a positive real return, first and foremost. Usually, we expect a real yield of around 2 to 2.5% over inflation before nominal bonds offer value. However, in the world of The New Normal, we are noticing that many countries, South Africa included, are running negative real policy rates in order to kick-start growth and to try and escape the debt trap that austerity is threatening. The implication for longer-dated real yields is that they are lower than one would usually expect.
The most recent CPI release in South Africa surprised positively, showing that inflation was only 6.1% in February – a pleasant surprise in the face of a market consensus expectation of 6.4%. This is encouraging for three reasons: the extent of negative real rates is slightly lower (only -0.6% versus a more extreme -0.9% implied by consensus), the likely peak in CPI will be lower, and CPI seems likely to return to the target range of 3% to 6% sooner than previously expected.
The repo rate is the other key variable which has a major impact on how government bonds are valued. At the March 2012 Monetary Policy Committee (MPC) meeting held by the SARB, the repo rate was held constant at 5.5%. As bond investors, we need to anticipate when the SARB will hike or cut interest rates. In a rising interest rate environment, one wants to be invested in short-dated bonds and cash and in a falling interest rate environment, one wants to own long-dated government bonds.
The unchanged repo rate was very much expected by the market. However, this MPC was all about the tone of the SARB statement. We spend a great deal of time analysing the MPC statements, as well as evaluating the questions and answer session after their issue. We do this in an attempt to assess whether the MPC is being dominated by the Doves (those seeking to prioritise growth over inflation, with a preference for lower rates) or the Hawks (those seeking to ensure inflation returns to the target range, regardless of growth concerns, with a preference for higher rates). That the SARB has allowed inflation to breach the upper end of the 3% to 6% CPI target range shows that the Doves have thus far dominated the MPC under Gill Marcus.
Our overall assessment was that this MPC statement was more dovish than the market had been expecting. The peak in CPI has been adjusted down to 6.5% in Q2 2012. It appears that the SARB expect CPI to return to the target range in the latter part of 2012, and in Q1 2013 it is anticipated that the average CPI for the quarter will be 5.6% - safely back in the range.
Importantly, inflation expectations have remained anchored around the upper end of the inflation target range. The SARB believes that cost push pressures remain the main drivers of inflation. What could force the SARB to hike rates would be a move towards more broad-based, second-round inflationary pressures, or demand driven inflation.
The clincher, for us, was the fact that an interest rate hike was not discussed at all by the MPC. There is now a very real possibility that the SARB might go through the entire up-cycle in inflation without having to hike interest rates. This would mean that the impact of rising inflation will be felt through a steepening yield curve. Once the peak of inflation has been confirmed, the yield curve will start to flatten again, and then long dated government bonds will start to offer value."
"The PSG Angle is an electronic newsletter of PSG Asset Management. To subscribe or read more, please go to to www.psgam.co.za".
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