KIM SILBERMAN: SA bonds offering value as Treasury becomes creative

Historically, a peak in the US Federal Reserve Bank (Fed) monetary policy hiking cycle accompanied by US yield curve inversion (when the 10-yr bond yield falls below short-dated bond yields) is a bullish signal for emerging market bonds. In May, the US yield curve inverted significantly, to ­‑175 basis points (bp). And, signalling the end of the hiking cycle, reserve currency central banks kept policy rates on hold in October. The Fed kept the policy rate at 5.5% where it has been since July’s meeting, as did the European Central Bank (ECB) (4.50%) and the Bank of England (BoE) (5.25%). Against this global monetary policy cycle backdrop, we see value in SA bonds at current levels. 

US Treasury yields fall as the probability of US recession rises

Why is yield curve inversion generally positive for bonds? Markets know that a curve cannot remain inverted and will correct in time and the process of dis-inversion is bond positive.

At the peak of a hiking cycle, tight financial conditions induce expectations of slower growth and inflation, causing markets to expect that future rates will be lower than current rates i.e., the yield curve inverts. Typically, as slower inflation and growth materialise and invoke a fear of recession, markets start to price for policy rate cuts, causing bond yields to fall i.e., bond prices rise. More precisely, heading into a recession, an inverted yield curve will start to dis-invert as shorter-dated bond yields, which are more influenced by the policy rate, fall faster than longer-dated bonds which are less affected by the policy rate. This is referred to as a bull steepening of the yield curve. 

Since May there has been considerable uncertainty r the US economic outlook. Strong labour market data has created concern regarding a recession or a reacceleration of US growth and inflation. From May to October the consensus was leaning towards a reflation of the economy, led by the labour market. The yield curve started to dis-invert but instead of bond yields falling, we saw them rise across the yield curve, with the long end rising faster than the front end (bear steepening), as expectations that the Fed would cut rates began to fade. This saw bond prices fall globally, as emerging markets followed the US markets. 

However, data since October, including weaker-than-expected CPI, PPI and jobs data, have increased the probability of a US recession, causing bond yields to shift lower across the curve and the market to start pricing for more aggressive Fed rate cuts. Bonds have rallied accordingly, with the SA 10-yr yield falling 80bp on the back of the US 10-yr falling 50bp. We expect the yield curve may continue to vacillate between bear and bull steepening, before capitulating.

SA bonds offer value as they are driven by global interest rate cycle

Looking ahead, we expect the recent trend with respect to softer US data will continue as Covid’s fiscal stimulus dissipates and the full, lagged effect of higher rates feeds through to consumer demand and corporate profits. This will see the US curve shift lower. Also, historically, it would be unprecedented for the yield curve to exit inversion via a bear steepener as opposed to a bull steepener. If a hard landing in the US were to materialise, we should see an even more aggressive fall in US rates. We expect SA bonds will be driven by price action in US Treasuries (USTs). 

The extent to which SA bonds can strengthen on the back of UST yields falling will be constrained by the extent to which domestic monetary policy can be accommodative. As an inflation-targeting central bank, the SARB is required to keep policy rates restrictive to ensure that CPI, which peaked at 7.8% in July 2022, returns to average 4.5% y/y on a sustained basis. The latest data for September surprised to the downside at 5.4% y/y such that our real policy rate is around 3.0%. While this is highly restrictive relative to real growth below 1.0%, it is extremely low relative to US real rates.

Higher SA debt a worry, but Treasury becoming creative

SA bond yield compression will also depend on SA sovereign risk, which is a function of fiscal or default risk. SA’s rand-denominated redemptions have averaged R33bn per annum over the past 5 years; however, over the next five years it will average R130bn per annum. And in 2031, local currency debt maturing will rise to R250bn per annum. This is concerning, considering SA runs a budget deficit of between R300bn and R400bn, which means not only do we need to raise debt to pay down maturing debt, but SA also needs to raise debt to pay annual bills. 

In addition, because the country’s credit worthiness has deteriorated in the eyes of investors, debt needing redemption that was issued in the past at par, needs to be refinanced at discount of around 83 cents. This runaway train is accelerating exponentially and unfortunately our Treasury has increasingly less control over the budget.

To its credit, the Treasury is becoming increasingly creative. To reduce the cost of debt, Treasury is shifting towards issuing cheaper shorter-dated instruments, such as T-bills, and has introduced Floating Rate Notes (with three- and five-year maturities), and a local Shari’ah product. More concessional foreign funding is expected as well as drawing down on the GFECRA (Gold and Foreign Exchange Contingency Reserve Account), estimated at R450bn.

• Silberman is economist and macro strategist at Matrix Fund Managers.