11 April 2018


by Mpumelelo Kondlo

In our bond market review, published in January 2018, we highlighted a number of events expected to unfold during the course of 2018. In particular, we had postulated on a potential rise in global yields precipitated by volatility and risk premia repricing higher. We further argued on the attractiveness of SA bonds. We continue to uphold this narrative.

During 1Q18, global yields have risen substantially. Yields on the US 10-year benchmark bonds rose by over 0.5% (2.4% to 2.95%) before ending the quarter at 2.75%. The Japanese 10-year benchmark rose as high as 0.095% from 0.05% at the beginning of the year, while German bunds touched 0.8% from 0.46% during the course of 1Q18. On the local front, bonds rallied during 1Q18, strengthening by over 50 bps.

Various factors have contributed to what has been seen in 1Q18. Most notably the upbeat economic data prints in developed economies which have been suggestive of these economies growing faster than the slow pace that previously persisted. The International Monetary Fund (IMF) has projected global growth at 3.9% for 2018, an upward revision from the previous 3.3% set in October 2017.

This global growth euphoria, particularly in developed economies, has sparked fears of inflation pushing yields higher.

This arises from the accepted theory where changes in nominal yields from period to period stem from a combined effect of changes in investor expectations about future inflation and the real returns investors demand.

Thus, the outlook going forward, not just for fixed income but across asset classes, weighs heavily on the expected inflation trajectory and the pace thereof.

The inflation issue has been a topical theme for the last 2– 3 years and its relevance, importance and implication today has increased. Much of the focus on the inflation puzzle has been centered on the Phillips curve. According to the Phillips curve, an environment characterised by tightening labour markets and a narrowing output gap should experience a rapid rise in inflation. This, however, has not been the case notwithstanding continued labour market strength and improving growth across economies. This has left market participants extremely puzzled.

We take the view that inflation is a process. Although impacted by temporary shocks, it remains fundamentally driven by endogenous dynamics and expectations. Thus, the inference drawn from the Phillips curve provides an empirical observation of the inflation paradigm though it lacks the complete theory thereof. Figure 1 below, provides a high-level version of the complete inflation process.

Figure 1: Inflation process

Fundamentally, inflation is a monetary phenomenon which, in its completeness, should include factors such as money and credit growth. This forms the starting point in the inflation process above. The Phillips curve, on the other hand, considers the final steps in the above inflation process thus omitting and failing to capture the importance of monetary growth in an economy. Accounting for money and credit growth, we provide a different basis on which we can analyse the present inflation puzzle and how we can use this process to form our expectations going forward.

A closer look at growth in US M2 money supply and US inflation in Figure 2 below, reveals a strong behavioural relationship. It can be seen that a rise in inflation has always followed from a sustained rise in money supply. Currently, we observe that the money supply growth rate has trended sideways since 2012. On average, US M2 money supply has been subdued averaging 6.4% p.a. since 2009, while other research shows that M3 (a slightly broader classification of money supply) has grown even more slowly (averaging 4.5%). This provides an explanation on the subdued inflation within this period. On the other hand, in the EU, M2 money supply has been rising rapidly from negative growth to positive growth since 2015. This has equally been followed by an increase in inflation over the same period. More broadly, across the Organisation for Economic Co-operation and Development (OECD), money and credit growth have slowed since 2008.

Figure 2: US CPI vs US money supply (% change, YoY)

It is without a doubt that we are in uncharted territory with numerous factors creating “push-and-pull” theatrics. However, based on our analysis, we do not share the same narrative of threatening runaway global inflation. We believe that federal authorities will keep inflation at bay. This is evident from Figure 3. The US Fed has over time managed to keep inflation within the required band.

More importantly, we hold the view that the global economy could be heading towards a record long expansionary cycle, characterised by a steady pace in inflation.

According to the National Bureau of Economic Research (NBER), the longest expansion cycle spanned a period of 10 years (March 1991–March 2001). The current cycle is in its ninth year (June 2009 to present) and appears set to span beyond the 10-year mark.

Undoubtedly, the end to a business cycle is never defined by its age but predominantly by tightening liquidity conditions, which result in a squeeze in money and credit growth. It is under these conditions where we would start fearing runaway inflation. However, current data suggest that we are miles from such an occurrence.

Figure 3: US PCE Core (% change, YoY)

We thus view global yields, particularly in the US, to be closer to their mid–term peaks. We do not see bond yields moving significantly higher from current levels. In the US, assuming real GDP of 2.5%, while core inflation moves to 2%, nominal GDP then becomes 4.5%. Based on historic correlations, the 4.5% nominal GDP growth implies longterm bond yields (30-year) of 4%. Given that the 30-year bond has moved as high as 3.2% this year, we expect a gradual move towards 4% in the long run (12 months out). This further implies that the US 10-year (currently at 2.85%) potentially has its mid-term peak level at 2.9% and should gravitate towards a long-run peak of 3.30%.

Figure 4: SA 10yr and US 10yr bond

Locally, bonds should remain strong through 2Q18. More specifically, the decline in the inflation deferential between SA and the US should provide support for the strength in SA bonds. The recent positive credit rating review on SA by Moody’s has lifted a major cloud of uncertainty and should provide a breather for foreign investors. The unsurprising rate cut by the SARB has also helped reinforce bond strength, although the cut itself had no impact on the market.



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