It’s getting real
The third quarter started on a positive note with a rebound in equities amid hopes of a dovish pivot from the Fed. The upbeat sentiment lasted well into August but was stamped out by a crisp hawkish message from Fed Chair Powell at Jackson Hole. The market’s outsized focus on headline CPI made for much volatility. The downside surprise in the July print supported risk appetite only to be followed by the modest upside surprise in the August reading leading to risk-off.
A key factor will be to what extent the labour market can rebalance to dampen wage growth in a bid to cap second-round inflation effects. This will be an important determinant of where the inflation rate ultimately settles, given that base effects will very likely lead to sharp disinflation in 1H23. Yet the delta may not be enough for the Fed to slow the pace of hikes if longer-term inflation expectations become unanchored.
Liquidity retrenchment has just begun
While the real policy rate remains negative based on short-term inflation forecasts, market-based real rates have reset sharply higher. This reflects not only expectations about monetary policy, but also liquidity conditions. The combined balance sheet of the Fed, ECB, BOE, and BOJ has declined by US$3.2trillion since the end of February, being down 10% y/y. This is notably lower than the -5% y/y trough in 2019.
It should be of concern that the momentum has waned quite rapidly despite most of the major central banks still implementing QE. The Fed is the only major central banks to have moved to QT (although not outright selling) in September.
The problem with declining liquidity and rising core real rates is that risky assets have to compete. Even within safe asset classes, such as DM bond markets, there has been risk discrimination. This was borne out by the market’s reaction to the UK’s fiscal experiment that seemingly relied on Modern Monetary Theory that deficits do not matter.
Lower liquidity reveals more strain
Deficits do not consistently matter – be they of the fiscal or current account variety. When liquidity is ample and growth is good then deficits are readily funded. However, when liquidity becomes more fragile and safer asset prices more attractive, deficits do matter – ask any EM that has experienced BoP strain or the need to restructure debt amid a financing hiatus.
The sharp reaction in the UK bond market may be seen as a sign that the bond vigilantes are back. Yet the outsized market moves were at least partly a function of linkages and feedback loops that were underappreciated by the regulators. Moreover, the close connection between major bond markets means that the spillovers from the UK market to the Eurozone and US markets have been large. Adding this to reduced market liquidity, in part due to curtailed risk taking activity by the banks, these outsized market movements post a risk to financial stability.
The stars are not aligned (yet)
A recent working paper from the New York Fed estimated a neutral real rate for financial stability, which they called R**. The greater the leverage in the financial system, the larger the risk for financial instability, and the lower the neutral rate. It tries to estimate the threshold of vulnerability and in this sense is similar to R*, which is the natural (or neutral) real rate for the real economy, although the determinants would differ.
The current estimate for R** is slightly negative, while for R* it is slightly positive and similar to the Fed’s long-run median dot of 2.5% less the core PCE target of 2.0% inflation, or 0.5% in real terms. The spot real Fed funds rate is currently -2.0%, which is well below R** and R*. However, if the Fed hikes to 5.0% by March next year, as priced by the market, then, assuming the consensus inflation forecast proves to be correct, it would put the real Fed funds rate at 1.0%. This would be well above R** and R*.
While the real economy warrants a period of tight monetary policy to correct the imbalances of the easy post-Covid stance, the tightening may have an adverse impact on financial stability. A factor to consider in this context is the rapid pace of real tightening. The real Fed funds rate has risen by 290bp in the six months to September. Based on the market pricing and the consensus forecast, the real Fed funds rate will rise by a further 300bp by March next year. This pace of tightening is a +2 standard deviation event.
While the real world may be de-globalising, the financial world is still very much integrated. As such, the cracks may not necessarily be seen at the origin of the tightening, but could show up elsewhere.
SARB is a price taker on global liquidity and monetary policy
Liquidity tightening amid a strong US dollar and QT is keeping the SARB on the front foot to ensure that real rate differentials do not go against the rand. While the MPC does not target the rand directly, they are cognisant of the potential inflation risk posed by excessive rand weakness.
As such, the short-term evolution of monetary policy will very much remain a function of what the Fed does. On this front, Q4 remains too early to call the policy pivot, unless something breaks.
Market developments
None of the major domestic asset classes beat cash (0.5%) in September, with notable losses across board. Beyond cash, fixed-rate bonds (-2.1%) were the outperformers, followed by inflation-linked bonds (-2.3%), equities (-3.8%) and listed property (-6.3%).
Similarly, Q3 also saw cash (1.4%) outperform, followed in the same order by fixed-rate bonds (0.6%), inflation-linked bonds (-1.0%), equities (-2.4%), and listed property (-3.5%). Over both horizons the weaker rand (-5.4% m/m and -10.1% q/q) would have been accretive to offshore returns.
No stopping the dollar
The dollar surged in September, reaching almost 115 on the DXY dollar index. The bulk of the strength was recorded against commodity-producing G10 currencies as recession risks intensified. While the dollar softened toward the end of the month, the Fed’s aggressive policy action and relatively better performance from the US economy boosted the greenback by 3.1%.
Official intervention temporarily stabilised the yen and yuan relative to earlier sharp weakness, but interest rate differentials continue to weigh on these crosses with potential negative spillovers to the region.
EM FX weakened by 3.8% against the US dollar, on average, with performance spread across the regions. While the main FX theme was dollar strength, there were a myriad of factors driving EM currencies. Recession fears dampened commodity prices, while political uncertainty increased. Early hikers, particularly in LatAm, have signalled a slower pace in tightening. While the SARB started hiking in 4Q21, the MPC is of the view that South Africa is lagging the global normalisation cycle, despite relatively well-behaved domestic inflation.
Weaker commodity prices, but not yet enough to push CPI sharply lower
Commodity prices posted an intra-quarter rally alongside other risk assets as global growth temporarily reaccelerated. The gains were, however, unwound in September, with prices falling by 8.3% based on the BCOM index, leaving the net return for Q3 at -4.8%.
Brent crude fell to an intra-month low of US$84/bbl, but recovered back to above US$90/bbl amid notional production cuts and still tight supplies. Refining margins have risen anew, particularly for diesel, which, alongside the weaker rand exchange rate, has put upward pressure on the basic fuel price.
The under-recovery is substantial, pointing to a petrol price increase of over 50c/litre for petrol and over 150c/litre for diesel in November. In isolation, this is not enough to push headline inflation back towards the 7.8% peak reached in July, but will make it more difficult for inflation to move below 6.5% by the end of the year.
Global prices and the weaker rand have lifted local agricultural commodity prices, despite a still positive outlook on the local harvest. Elevated food price inflation is another reason to expect a sticky CPI profile in the very short term.
Rand starting to reflect more than dollar headwinds
The rand was a relative underperformer versus the US dollar, both in September and during Q3. While the trade-weighted rand is only marginally lower year-to-date, it is now more than 5.0% weaker year-on-year. Admittedly, this is nowhere near as sharp as the 16% decline against the US dollar, but it is moving into inflationary territory.
The rand is trading outright cheap versus our 16.00 – 17.00 fair-value range. Cyclical headwinds, such as lower commodity prices, have been amplified by structural constraints, such as load shedding and political uncertainty. While the trade balance should remain in surplus in 2H22, there are notable downside risks amid power rationing and transportation disruptions. In the absence of a Fed pivot, Q4 is set to be another challenging quarter for the currency.
Weaker rand adding to upside inflation concerns
The weaker rand has contributed to the market pricing in a more aggressive monetary policy response by the SARB. During September, the FRA curve rose by 58bp, on average, and by almost 100bp during 3Q22. The market is pricing in a peak repo rate of 8.25%, which would make the policy stance outright restrictive. More hawkish pricing has lifted money market rates more broadly, with the 12-month NCD yield rising to 8.6% during September. This put the implied real rates firmly back in positive territory based on a reasonable inflation outlook of around 5.5% in 2023.
Sharp re-pricing in DM bonds
Global bond markets faced a confluence of malign reinforcements in September. Hawkish DM policy action, QT, FX intervention (which would lower non-resident holdings of US Treasuries), and fiscal laxity in the UK sent global bond yields soaring. The repricing was largely driven from the real yield side, with breakeven inflation compressing despite upside inflation surprises.
The US nominal 10-year yield breached 4.00% intra-month as the TIPS equivalent reached 1.6%. The nominal and real curves remained firmly inverted on Fed funds pricing and moderating growth expectations. Uncertainty has been reflected in a rising term premium, while long-run pricing on monetary policy has also shifted meaningfully higher. This is despite the Fed’s long-run dot remaining unchanged at 2.5% in the September forecast update.
Higher DM yields making it harder for EM to compete
While higher DM yields spilled over into EM bond markets, the effect was not uniform with wide-ranging betas evident in September. Poland and Hungary were high-beta, rising by 102bp and 96bp, respectively, but Brazil rallied by 28bp, rendering it a low-beta holding for the month.
SA’s 10-year yield rose by 45bp, resulting in a middling loss. At over 11.00%, the 10-year yield is screening moderately attractive considering pending domestic disinflation and stable domestic issuance, with a small chance of lower issuance due to the revenue overrun. However, with the Fed’s terminal rate and peak in core inflation still unclear, EM bonds will face ongoing headwinds in terms of global fundamentals and flows.
Rising DM yields dampened demand for SA bonds with net foreign outflows of R6.5bn in nominal terms during September. For Q3, non-residents bought a total of R7.7bn, which amounted to 11% of government fixed-rate issuance. Banks effectively took up all of the issuance in September and 50% of the Q3 funding. Other financial institutions (largely comprising of CIS funds) accounted for 20% of Q3 issuance.
Government issued a total of R36.1bn in the 5-year floating-rate note in Q3, with banks taking up the bulk of the new instrument. As at end September, banks accounted for 74% of the outstanding amount, with other financial institutions holding 21%.
Real rates roil equities
Global equities were hit by higher real rates, recession fears, the ongoing Russia/Ukraine war, and China’s evolving property concerns. The latest sell-off in markets does not reflect lower earnings expectations, but rather the impact of the higher discount rate. Margins remain high, particularly in the US, with earnings revisions tipping only modestly negative. Risk aversion was rife, pushing the S&P500 down by 9.3% and Eurostoxx by 6.3%.
The MSCI World Index dropped by 9.3% in September, taking the price level back to what prevailed ahead of the Covid crunch. EM equities have fared worse, with the MSCI Emerging Market Index down by 11.7%. None of the major country indices managed to eke out a gain in dollar terms in September. Mexico was the best performer, down only 0.4%, while Norway was the worst performer, with a 19% slump.
The MSCI South Africa Index was a marginal outperformer versus the average, falling by 8.9%, with half of that due to the weaker rand. The ALSI lost 4.1% and the SWIX lost 3.9% on a total return basis. The underlying performance was bleak, with only basic materials (1.3%) scratching out a positive return thanks to precious metals and mining (5.6%) that benefited from a staggered rebound in gold and platinum prices. Telco’s (-2.3%) managed to outperform the market. Industrials (-5.1%), consumer staples (-5.5%), financials (-6.0%), health care (-6.4%), consumer discretionary (-7.4%), and technology (-7.8%) buckled in the face of global and local headwinds.
