The bond market anticipates Reserve Bank reactions to a higher oil price – meaning more bad news for the SA economy.
The RSA bond market and the rand weakened on Friday: the yields on RSA bonds rose markedly across the yield curve. The RSA five-year yield added 22bps (0.22 percentage points) and the 10-year yield 24bps.
The spread between RSA yields and their equivalent US Treasury Bond yields (the carry) also widened by about the same number of basis points – indicating that not only did the rand weaken on the day but still more rand weakness was expected on the day.
The gap between RSA five-year and 10-year vanilla bonds and their inflation-linked alternatives also widened, indicating more SA inflation expected over the next five and 10 years, about two tenths of one per cent per annum more inflation expected over the next five and 10 years, with inflation now expected to average almost 7% over the next five and 10 years (see figure 3 below). The real yield on the inflation-linked five-year bond, at 2.43%, was unchanged on Friday, indicating that the higher nominal bond yields reflected a changed view of the outlook for inflation.
Further confirmation that it was inflation expected rather than real forces at work was that the sovereign risk spread was largely unchanged on the day. The extra yield offered on an RSA US dollar-denominated bond edged up only marginally, while the cost of a CDS swap that insures RSA debt against default, actually declined on the day (see below).
A large part of the rand weakness on Friday can be attributed to global rather than SA-specific forces at work, in the form of a degree of US dollar strength against both its peers (the euro et al) and against an Index of emerging market currencies that accords an 8.33% weight to the rand (see below).
Having identified more inflation expected behind the higher RSA bond yields and spreads, it remains the task to explain why inflation should have been expected to increase. Perhaps it has something to do with higher oil and metal prices. A combination of a higher oil price in US dollars and a weaker rand would be expected to add to inflationary pressures and depress domestic spending. The rand and US dollar price of a barrel of oil did spike higher on Friday. We can only hope that this supply side shock for inflation will be ignored by the Reserve Bank. Past performance alas makes it likely that the Reserve Bank would raise rather than leave interest rates alone in such circumstances. Perhaps this was also behind the spike in RSA interest rates across the yield curve. Short rates also rose on Friday, indicating an expectation that the Reserve Bank is more likely to increase the repo rate.
Our argument is not with the market but with the Reserve Bank that continues to treat supply side shocks to inflation as if they are permanent rather than temporary. Given all else that plagues the economy, such possible monetary policy reactions can make even the strongest still standing feel very weak. 7 November 2017
