• Following the last MPC decision and the accompanying statement, rate hike expectations have intensified or at the very least remained buoyant. The SARB aims to be pre-emptive and contain inflation by reducing negative real interest rates to something it deems more sustainable and normal. That implies several more rate hikes, although that should not be considered a guarantee that the SARB will push through with all they have signalled.
• The global economy is showing some signs of slowing down. In last week’s report on the US economy, it is clear that some sectors are under severe pressure and that the economic surprise index is pointing to weaker data ahead. The yield curve is flattening as short-end rates rise and the stock market has started to price in weaker earnings results going forward. Should that gain traction, the likelihood is that the Fed will walk back some of their hawkish rhetoric and give the markets some stability. The concern is that inflation remains frustratingly high and does not offer the Fed or any other central banks the flexibility to be less hawkish.
SARB guidance points to a repo rate of 6% by the end of 2023. The SARB’s more recent communication with the market will embolden the hawks to keep yields a little more buoyant for longer. Local bond yields have risen in response, to help induce more conservative monetary policy and help constrain inflation, so a pause in hiking later this year is still possible.
At the risk of sounding like a stuck record, there has been a sharp upwards shift in the repo rate expectations of the professional market since the last report a month ago. The upward revision to rate hike expectations comes on the back of the topside surprise in US CPI, adding to bets that the Fed will turn even more aggressive in its policy tightening. Heading into the FOMC meeting, the market is pricing in a more hawkish move, with consecutive 75bps rate hikes in June and July now close to fully priced.
Ongoing supply chain issues, elevated international oil and food prices and weakness in the ZAR are underpinning fears that inflation will remain elevated for longer. The ZAR has come under considerable selling pressure in June, climbing back to levels north of R16.00/dlr. Brent crude meanwhile has risen back to around $125 per barrel amid renewed supply concerns after OPEC downwardly revised its output forecast. The risk to the market view remains that investors are underestimating the degree to which a credit cycle can reverse, given how leveraged the global system has become. This holds the potential to change expectations to become a little less hawkish over time.
Rate expectations shifted a long way in a short space of time
The South African Reserve Bank made it clear at its May MPC meeting that it is committed to achieving its primary goal of price stability as it hiked interest rates by 50bps. The central bank looked past mounting growth concerns, domestically and abroad, as external price shocks continued to drive inflation higher. Despite pre-emptively hiking rates in November, the SARB moved in the same magnitude as the Fed in May in order to maintain SA’s monetary policy differential with the US. The bold policy move helped provide a boost to currency fundamentals. Looking ahead, we expect the SARB to continue hiking rates in 50bps intervals at its remaining MPC meetings in 2022. That said, given that monetary dynamics, as measured by M3 money supply and credit growth, are relatively tight against the backdrop of weak economic growth, we remain of the view that the professional market continues to price in too much rate hike risk.
Rates have a long way to go to get back to neutral
The accompanying chart shows that while growth risks are intensifying, monetary policy in SA remains loose when looking at the spread between the Repo Rate (black line) and the neutral policy
rate (red line).
While we continue to caution that the professional market is overly aggressive in the implied interest rate path, there is no question that the spread between the Repo Rate and the neutral rate needs to be compressed. With interest rates expected to rise another 150bps by the end of the year, the spread is expected to narrow considerably.
Currently, SA’s neutral rate sits at around 6.75%. This implies that the SARB will have to hike the Repo Rate by 200bps to get rates to a neutral level. Our base case scenario suggests that the SARB will raise rates by a further 175bps in the current rate hiking cycle. The tightening is expected to come to an end in Q1 2023, with inflation likely to cool in the first few months of next year as the high base effects take hold.
Investors across most DM jurisdictions have moved swiftly to preempt the move of the central banks against inflation. Across Europe, the UK, and North America, bond yields at the short end of the yield
curve have shifted sharply higher.
The rise in yields has come long in advance of the central banks actual rate hikes and is a response to the guidance already given.
Forward guidance has now become an actively managed tool for the central banks that they will deploy to get the markets to do much of the heavy lifting and soften the blow of monetary tightening in a bid to reduce the amount of actual tightening the central banks eventually implement.
The most recent rise in yields has been amongst the sharpest on record. One would have to go back many decades to find a comparable spike in bond yields, and even then, the spike would not be as co-ordinated as it is now. The point to make, is that the spike in inflation is broad-based and so too is the spike in interest rates.
DM Yield curve
While short-end rates are rising, the middle to longer dates are not rising as quickly, giving rise to a general flattening (black line).
Typically, the flattening of the yield curve is associated with a business cycle slowdown and is a result of the short-term rates (chart above) rising faster than the long-term rates.
This particular chart understates the degree of flattening in the US as it includes the likes of Switzerland and Japan. The flattening of the curve in the US is something that should concern everyone.
Historically, the yield curve has tended to correlate quite closely with the VIX. When interest rates are rising, that is typically due to a strong economy that generates strong earnings and reduces the need to hedge against a drop in equity markets. This time, there has been some dislocation due to the uncertainty related to the pandemic and the VIX has reset higher. It will likely remain buoyant and may even rise further in the months ahead if stock markets start to crash and central banks move to reduce their monetary tightening in a bid to prevent a recession.
Inflationary pressures remain well contained
According to the latest run of the inflation risk indicator, the balance of forces remains in favour of higher inflation. A combination of high energy prices, high food prices, shipping costs and supply chain disruptions mean that input factors of production are high and that inflation will therefore remain higher for longer.
Add to that the effects of significant monetary easing in recent years by the world’s largest central banks and inflation has enough space to breath. To help contain inflationary pressure subside and to
unwind some of the effects of policy that was arguably too loose for too long, the central banks are now being forced to normalise policy.
The adjustment will be painful.
In SA, the inflation risks are far more contained, but remain elevated.
The SARB has indicated that it will do what it takes to retain its credibility as an inflation fighter in order to protect its credibility. The SARB’s pre-emptive move has set the tone and investors are under no misconception that the SARB will do what is necessary to return inflation back to the 4.5% midpoint of the 3-6% target range.
Inflation pass-through will be limited
The latest credit cycle remains relatively subdued. So long as that remains the case, the pass-through into inflation will stay reasonably well contained. The second derivative of inflation (red line) is trending to zero and will break above, but underlying momentum remains subdued, and inflation is not yet a runaway train.
As the monetary space is limited, inflation will struggle to intensify sustainably. Any spikes in cost-push pressures could be more recessionary than inflationary. Ignoring the fuel levy that may be added back into the fuel price, inflation could even surprise expectations to the downside.
That does not mean that inflation cannot rise any further. It means that the momentum behind the rise is weaker and that any depreciation in the ZAR will not contribute strongly to the inflation outlook.
The final point to make is that the ZAR has been fairly resilient and that this is certainly not the main source of inflation.
Credit cycle remains weak and will restrain inflation
Inflation is rising at the fastest rate in six years. As growth in M3 has accelerated, there has been some room for inflation to manifest.
However, growth in both M3 and PSCE have been higher historically.
SA’s sluggish economy, structural constraints, high unemployment and the impact of load shedding has all weighed heavily on the credit cycle. The property market has been subdued, banks have been conservative in their lending practices and restricted any demand-pull inflation.
This might also explain why SA’s inflation has not been as severe as it has been abroad and why the local economy continues to run a trade surplus.
It also suggests that so long as the SARB remains conservative, that it is unlikely that SA will suffer with any form of runaway inflation as is evident in more developed economies. On the contrary, domestic inflation will remain reasonably well contained, although it will briefly rise above the upper limit of the target range, especially if the government add the fuel levy back into the fuel price.
Inflation spike more acute abroad than in SA
As global inflation rises to the highest levels since 2009, it is worth noting that SA’s inflation has frequently been higher in the past decade. By comparison, developed economy inflation has accelerated to a multi-decadal high, highlighting how the inflation episode witnessed abroad, is substantially more acute than the inflation episode in SA.
However, while SA’s inflation outlook may remain more contained, that does not mean that the SARB will not keep pace with DM central banks. On the contrary, it may feel that it is in SA’s interests to do so to prevent negative speculation against the ZAR and to ensure that no second-round effects to inflation could arise.
Nonetheless, the fact that inflation in SA is accelerating at a less rapid pace will also lend some support to the ZAR on a trade-weighted basis which over time, will also help to contain some of the imported inflation, that is so difficult to escape.
Slowly, high base factors are being priced into inflation that will see the cycle start to reverse later this year and into 2023.
The SARB has moved pre-emptively. Furthermore, there are no demand-driven inflationary pressures within the SA economy. Not only is the credit cycle subdued, but SA is facing many structural headwinds. What inflation does exist operates out of the realm of what the SARB can control. At best, the SARB could argue that they are guarding against inflation expectations turning more entrenched at higher levels. At worst, it is only adding to the misery of households already struggling with vastly reduced disposable incomes.
Finally, it is worth noting that while many developed economies are faced with runaway inflation, SA is not. On the contrary, inflation throughout this period has remained within its inflation target range. The SARB would argue that inflation is well above the midpoint and needs attention. But understanding the root cause of inflation is then just as important. The risk, is that forecasts of inflation are too mechanical in their make-up and are assuming that the Fed and other major central banks will be able to carry out the full extent of the tightening they have signalled. There is a more than even chance that they can’t and that doing so would threaten the stability of the global economy to such a degree that it would be counter-productive.
Written and compiled by George Glynos & Kieran Siney, ETM Analytics, for TreasuryONE