SA interest rates move higher in 1Q24 on better-than-expected US data
Over the first quarter of 2024, emerging market bonds have contended with a massive shift higher in global interest rates, causing the JP Morgan local bond index to lose 4.0% YTD (Figure 1). In SA, higher-than-expected domestic inflation and election jitters added to the uncertainty risk premium priced into sovereign debt, which has breached 13.0% at the long end, underperforming the EM index (Figure 2). South Africa’s CPI is now expected to average above 5.0% in 2024 and 2025, reducing the number of rate cuts priced by interest rate derivatives.
Comments by the US Federal Reserve (Fed) and upside surprises to US data saw US forward rate agreements (FRAs) revise January’s expectations for 180 basis points’ (bps’) worth of cuts to only 70bps of cuts currently. And, although EU inflation moderated to 2.4% in March versus 2.5% expected, inching closer to its 2.0% target and supporting expectations for a first cut in June, January’s expectations of 150bps’ worth of cuts have been pared to 86bp. We note that the Swiss National Bank cut its policy rate by 25bp in March and cited that it expected other central banks would be cutting rates in the near future, providing it with “leeway to support economic development by cutting interest rates early on”.
Figure 1: Emerging market bonds dependent on US yields
Figure 2: SA has underperformed EM since May 2023
Source: Bloomberg, Matrix
The SA bond curve shifted higher by between 50bp and 60bp in March, and 65bp and 95bp over the quarter, while swaps shifted higher by between 15bps and 32bps on the month and 40bps to 80bps over the quarter. SA’s FRA curve steepened, with the front end rising by a few basis points, and the 9×12 and 15×18 rising 15bps and 20bps respectively. At the end of March the derivatives market implied a total of only 60bp of cuts by mid-2025.
In April (month-to-date), post the release of the US’s March CPI print, which saw services CPI accelerate to 5.4%, South African interest rate derivatives started to price in interest rate hikes in SA! This implies that rates have dislocated from inflation expectations, which have not changed month-to-date.
Central banks face an existential threat
A consistent theme in our monthly commentary has been the dilemma facing the Fed, that although real interest rates are historically high, data releases indicate that the US consumer remains resilient, and financial conditions remain loose.
Figure 3: Relationship between financial conditions and interest rates has broken down in the US
Interest rates are likely to matter less during periods of fiscal dominance. In the US, from May 2020 to May 2021, Covid stimulus measures resulted in consumers’ real disposable incomes rising 16%. This allowed savings to rise from a long-term average of 7.0% of disposable income to 26% of disposable income! Those savings allowed consumers to deleverage, delaying the effect of higher interest rates on credit. It also allowed workers to negotiate better wages, delaying the pass-through from lower CPI inflation to lower wage inflation.
The apparent ineffectiveness of interest rates on inflation and growth has raised questions about the role of policy rates in the current global business cycle. If high real rates can coexist with loose financial conditions on a sustained basis, how effective is monetary policy? In other words, do policy rates matter?
SA Reserve Bank (SARB) governor Lesetja Kganyago added to this debate recently, arguing that the current generation has a lower tolerance for inflation, having become accustomed to the post global financial crisis (GFC) period in which inflation remained unusually low. The role of central banks and monetary policy is being questioned, including their ability to control and forecast inflation: central bank credibility is currently at stake.
The Bank for International Settlements (BIS) has responded and recently released a paper entitled The contribution of monetary policy to disinflation evaluating the “role of monetary policy in the 2021–23 inflation hump”. Perhaps predictably, it argues that while much of the post-pandemic inflation increase was due to sectoral shocks on which monetary policy has little traction, the inflation unwind would have been slower and less complete without monetary policy tightening; i.e. had central banks not increased policy rates, real interest rates would have fallen sharply, stimulating aggregate demand and keeping inflation high.
This debate is important for investors as it is key to our understanding of when the Fed may start to cut and by how much. Unlike in previous cycles, it has become more important to monitor financial conditions as well as inflation: the Fed may only need to cut the policy rate once financial conditions tighten, as opposed to when inflation is comfortably below 3%. The Fed has stated repeatedly that it will cut rates later this year. If cuts do not materialise, it is likely that financial markets will be disappointed, and rates and equity markets will need to weaken further.
A revision of South Africa’s inflation target
Lesetja Kganyago has accepted another 5-year term as SARB Governor. In a recent interview he discussed updating and reviewing the SARB’s 5-year strategic plan, starting in 2025. Of significant importance will be a review of the inflation target, which is currently 3% to 6%. Over the previous 5 years, the SARB has been successful in adjusting inflation expectations lower. It was made clear that inflation at or below 6.0% was no longer acceptable, and that the SARB’s inflation target is the middle of the band, or 4.5%.
The Governor explained that serious technical work has already been done, concluding that inflation targets must be more in line with South Africa’s trading partners, which would imply something closer to 2%. The point was re-emphasised that there is no virtue in high inflation, and that lower inflation improves competitiveness. In addition, the governor noted that credibility is not bestowed on you, you have to prove you act independently, “without fear or favour”.
While the governor has often referenced a preference for adjusting to a 3.0% target, we caution that administered prices (excluding fuel) have averaged 7.3% since 2008 and are unlikely to moderate due to the rising cost of doing business in South Africa. If we assume administered prices (ex fuel) run at 8%, the remaining CPI basket would need to run at 2.3% for headline inflation to reduce to 3.0%. On the other hand, having guided the market towards an adjustment to 3.0%, there would likely be a negative reaction to adjusting the target to a higher number.
The inflation target is set through a conversation between SARB and National Treasury but the Ministry of Finance will make the announcement. Importantly, the process needs to be robust, evidence based, and have a clear timeline.
South Africa’s upcoming elections
Looking ahead to the elections on 29 May, our base case is that the likelihood of a market negative outcome is small.
Analysts have provided the investor base (both local and offshore) with clearly defined and delineated scenarios for which there are bearish, neutral and bullish narratives. Post the election results being published, the market is likely to react to the news based on which scenario is most representative of the possible reality. Thereafter it is likely that the initial sentiment will subside, and markets will look for evidence of increased leanings either towards a more populist government or one that is more growth oriented. If there is an ANC coalition with the EFF, the market reaction is likely to be negative and more extreme and persistent. All other scenarios should be relatively well received.
Considering our base case, we expect a positive kneejerk reaction by the bond and currency markets on the day the election results are released (using 2019 elections as a proxy this would be 1 June), but we expect this to fade over the subsequent two weeks as markets await the outcome of coalition negotiations. According to the constitution, within two weeks of the election results being announced the National Assembly must sit to elect the Speaker and the President. We expect coalitions will need to be finalised within that two-week period.
We note that President Cyril Ramaphosa has extended the tenure of people in key leadership positions i.e. the Chief Justice, SARB governor and head of SARS, which should provide investors with comfort that these institutions will remain credible, at least with respect to their leadership, reducing the risk of South Africa’s sovereign risk premium widening more than is currently priced.