Global rates: What they mean for SA assets

Whither interest rates: up, down or sideways?

The most important feature of global financial markets in 2014 was the significant decline in long term government bond yields. On 1 January 2014 the 10 year US Treasury was trading at a 3.03% yield and the German Bund offered 1.94%. On Friday 16 January 2015 these yields had fallen to 1.83% and 0.46% respectively. These developments, led by German yields, were a great surprise to a market that was expecting both rates to increase, judged by the upward slope of the yield curve a year ago.

The US 30 year Treasury bond offered 3.96% a year ago. It now yields 2.45%, still above the 10 year rate, thus revealing that the market still expects interest rates to rise, but by much less and more gradually. The 10 year US Treasury is priced, in the futures markets, to rise from the current 1.84% to 2.08% in a year and to only 2.86% in 10 years’ time.

Long term interest rates in SA moved in the same direction and this trend lower accelerated in January 2015. Not only did long rates fall but the gap between long and short rates has narrowed sharply. Short term rates in SA have held up and only very recently has the money market revised its view that short term rates would be rising in 2015. The market would now appear to have put off any expected increase in short rates to 2016 and now appears to expect short rates to rise by about 1%t (100bp) over the next three years.

These unexpected movements in SA interest rates, long and short, have had a significant influence on the share prices of those companies listed on the JSE whose performance is known to be very sensitive to interest rates, for example property companies, banks and credit retailers. Changes in interest rates influence not only their cost of doing business but also stimulate or restrain demands for their services and top line growth. Our index of large market cap interest rate-sensitive stocks on the JSE performed as well in 2014 as the JSE-listed Global Consumer Plays and the S&P 500 (in common currencies) – well ahead of almost all the major stock markets in 2014¹.

Clearly interest rate trends matter a great deal for equity valuation in SA and had a powerful influence on the JSE in 2014. What the does the future hold for interest rates in SA? In 2014 and to date in 2015, RSA yields moved very closely in line with the rand/euro exchange rate. As we show below, interest rates in SA fell as the rand gained value against the euro. This relationship has held up very well this year.

This relationship (which has not always been as strong as this), between the euro/rand and the RSA yields makes every sense. It is weak growth and the threat of deflation in Europe that has sent all interest rates lower, including those in SA. It is these lower rates that have widened the spread between euro and US dollar and RSA rates even as rates have declined, adding to the case for holding dollars and rands. The dollar is strong and the rand is stable, so improving the outlook for inflation in SA in a deflationary (at least in dollars or euros) world.

The direction of economic activity and inflation, and so the exchange value of the euro, will continue to hold the key to the direction of interest rates in SA. This week the European Central Bank (ECB) hopes to add quantitative easing (QE) to its repertoire of instruments designed to avoid deflation and stimulate growth in Europe. We wait to see how much QE will be undertaken and how it will affect interest rates in Europe. In and of itself, QE would lower interest rates. However if QE is thought capable of reviving the Eurozone economy, then this would counter expectations of slow growth and deflation and might limit the downside to euro interest and exchange rates. Our sense is that provided the spread between US and euro rates holds up (currently about 1.4%) a strong or at worst stable US dollar/euro rate should be expected. Interest rates in SA would then move sideways at worst and possibly lower, with long rates continuing to lead short rates. If the rand holds up on a trade weighted basis (weaker against the US dollar and stronger against the euro), then the chances of inflation in SA surprising on the downside improves. Less inflation and less inflation expected portend lower (not higher) interest rates in SA.