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Fixed Income
11 August 2014
Market dynamics
11 August 2014
Update - Global and local interest
rates
•
Risk aversion reduces following an easing in
geopolitical tensions (at the end of last week), but
uncertainty prevails.
•
US yield curve flattens as Treasuries benefit from flight
to safety even though economic indicators point to
stronger momentum in July.
•
EM currencies stabilise as accommodative monetary
policy in DMs continues to provide support.
•
The FOMC minutes and papers delivered at the
Jackson Hole conference are event risks from the Fed
that we expect during August.
•
EUR/USD is trading in a range of 1.3300 to 1.3450
and a narrowing in interest rate differential could
translate into more weakness.
•
Local money market rates edge higher but Abil’s share
price collapse and the subsequent SARB-led rescue
measures have not had any distortionary effect on
rates or term premiums.
•
Derivative rates continue to track the ZAR but intraweek volatility has not spilled over into an adjustment
in rate expectations.
•
Manufacturing production contracted by 0.4%q/q in Q2
14 with July’s Kagiso PMI signalling a further
contraction.
•
Retail sales and mining production are the key
domestic economic releases scheduled in the week
ahead.
Key drivers
•
South African financial markets had to deal with a
confluence of international and domestic dynamics
over the past week. Internationally, geopolitical
tensions flared up as Russia announced counter
sanctions against some of the G7 countries and the
US re-engaged in Iraq with military strike action
against the ISIL. Locally, ABIL’s results (and its
subsequent placement under curatorship), together
with Eskom’s need for a capital injection in view of
being placed on credit watch by Standard and Poor's,
were the main news flows. Towards the end of the
week, sentiment improved following the end of
Russia’s military tests and pro-Russian rebels’ call for
a ceasefire with Ukraine.
•
The reaction of EM currencies and local bond yields to
these events was short lived. In part, while geopolitical
tensions have been the catalyst for the sell-off, the
compression of risk premia on financial assets has
contributed to the kneejerk reaction in EM. This
underscores the concern of some central banks over
financial stability as risk appetite has been fuelled by
expectations that monetary policy in DMs would
remain accommodative for an extended period.
Tertia Jacobs: +27 (0) 11 286 8659 | [email protected]
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the deposit rate to -0.1% at the June meeting, and a
moderation in foreign capital inflows into equities. At
last week’s press conference, Mr Draghi indicated his
support for a further depreciation of the EUR. In June,
CPI inflation receded to 0.4%y/y, the lowest rate of
increase since 2009. While a decline in energy prices
was mainly behind the moderation, disinflationary
forces have not dissipated. Hence, a weaker currency
is needed to put a floor to prices.
Flight to safety into US Treasury yields continues
to anchor EM bond yields and currencies
•
The US yield curve flattened as geopolitical tensions
overshadowed a spate of strong economic indicators
for July. Flight to safety pushed the US 10-year
Treasury yield down to 2.38%, but it ended the week
4bps higher at
•
It is unlikely that a decline in risk aversion witnessed
towards the end of last week will lead to a sudden
steepening of the US yield curve as Ukraine, Russia
and Iraq continue to unfold. However, if tensions do
not escalate, Fed communication of the recovery in the
labour market, wage inflation and its forward guidance
could become a more important driver of risk premia.
Event risks that could potentially spark an adjustment
in short-term interest rate expectations and yields
across the maturity spectrum in the second half of
August emanate from the Fed’s thinking about the
labour market and inflation. Minutes for August’s
FOMC meeting are to be published on 20 August. The
Jackson Hole conference is scheduled for 21 to 23
August. The topic “Re-Evaluating Labour Market
Dynamics” could provide more insight into Ms Yellen’s
analysis of the considerable slack in the resource
market and policy response.
•
Members of the Fed such as Vice Chair Fischer are of
the view that monetary policy should remain
accommodative as the economic recovery has been
well below average. That said, the conference is to be
held amidst growing concern of risks to financial
stability as valuations of risk assets have become
stretched. This could again lead to a disorderly sell-off
in EM financial assets and currencies once the Fed
embarks on a path to normalise monetary policy.
•
We remain of the view that the EUR/USD is likely to
trade lower in coming months. The economy’s
performance and the consequences of the stand-off
with Russia on consumer and business confidence
and exports will become more evident. This is in
contrast to the United States where confidence of a
more sustainable economic recovery has increased.
•
Other dynamics to monitor in the Eurozone are the first
of the six TLTROs to be conducted in September. The
ECB expects demand from banks of EUR450-850bn.
This not only holds implications for bank credit
extension but also for liquidity. An increase in money
market liquidity could continue to suppress money
market rates and anchor bond yields which in turn
could reduce support for the EUR/USD.
Local money market rates edge higher
•
Abil’s share price collapse and the subsequent SARBled rescue measures have not had any distortionary
effect on money market rates. South Africa’s banking
system remains sound and Abil does not present
systemic risk to the financial system. This is supported
by anecdotal evidence that none of the banks had to
raise term premiums on deposits.
3m JIBAR vs 3m Treasury bill yield
EM currencies vs USD
Source: Igraph
Source: Bloomberg
EUR/USD steady in a lower trading band though
interest rate differentials have become more
supportive of the USD
•
The EUR/USD is trading in a lower band of 1.3300 to
1.3450 in August after being caught in a range of
1.3500 to 1.3800 for most of the year. The catalysts for
the recent weakening of the EUR/USD have been a
widening of interest rate differentials, as the ECB cut
•
Money market interest rates have nonetheless drifted
higher over the past week. This does not signal an
adjustment of interest rate expectations or liquidity
pressures. Instead, a stubbornly high yield on the 3m
Treasury bill yield has exerted upward pressure on the
3m JIBAR rate which climbed from 5.958% to 6.025%
as the 3m TB yield has been issued at a level above
the 3m NCD’s for eight successive weeks. In turn, the
increase in the 3m JIBAR rate has caused a repricing
of the front strip of the FRA curve, i.e. the 5x8 FRAs
have increased from 6.31% at the end of July to
6.37%. The increase in the 1year swap rate resulted in
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an upward adjustment in the 12m JIBAR rate to 7.15%
from 7.10%.
•
•
Thus, following last week’s intra-week turbulence, the
FRA curve has not changed the probabilities of an
expected 25bps increase of the policy rate at one of
the two remaining MPC meetings this year. This is in
line with our base case interest rate forecast. Longer
dated FRA rates forecast a rise in the 3m JIBAR rate
to 7.37% in 21 months compared to our forecast of
7.20%. Our view is slightly more moderate as we see it
peaking at around 7.20%.
Swap rates continue to track movements in the
USD/ZAR in between MPC meetings. During last
week’s turbulence, swap rates moved higher across
the maturity spectrum before settling down at levels
more in less in line with the close of the previous week.
The bond market, on the other hand, exhibited hardly
any reaction to the movement in the ZAR. Mid-long
dated bond yields were about 5bps higher in contrast
to the long-end of the curve that were steady. Nonresident selling of local currency bonds last week
amounted to R2.9bn compared with R4.4bn in the
previous week. South Africa’s 5yr CDS spread
widened briefly to 202bps from 189bp before retreating
to 190bps today. A combination of the global and SA
specific factors, e.g. investors hedged long position in
Eskom and ABIL international bonds (this preceded
the ABIL rescue package announced yesterday). The
USD/ZAR is expected to focus more on international
dynamics (see discussion above) in the coming week.
EM currencies remain vulnerable to forward guidance
by the Fed as well as flight-to-safety trades in the
event of an escalation in geopolitical risk.
EM CDS spreads
Source: Bloomberg
•
The domestic economic calendar is sparse this week
with only June’s retail sales and mining production
data to be published on Wednesday and Thursday
respectively. These outcomes will provide more insight
into the expected growth rate for Q2 14, scheduled for
26 August. The contribution of manufacturing to Q2 14
GDP growth is negative as output declined by
0.4%q/q.
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