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Factors are very conducive to lower bond yields

Posted On Thursday, 02 October 2003 02:00 Published by
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If a psychologist had to make an evaluation on the character of the bond market, it would probably be diagnosed as suffering from a bad case of multiple personality disorder.

October 2, 2003

If a psychologist had to make an evaluation on the character of the bond market, it would probably be diagnosed as suffering from a bad case of multiple personality disorder.

For most of last week and early on Monday this week, the market traded in very low turnover while the yield ticked incrementally lower.

Then on Tuesday morning it lurched into action with good volumes trading. The R153 rallied 15 basis points in 90 minutes.

It was similar to sleeping peacefully in an aeroplane when it suddenly hits an air pocket. Some enjoy the feeling while others rush to grab the "courtesy bag" from the seat pocket.

The excitement started when the publication of money supply and private sector credit extension data for August showed an increase at was less than the market had anticipated.

This was compounded by a sharp drop in producer inflation, from 1.5 percent in September to 0.2 percent in August - well below the market forecast.

During all this excitement, the rand displayed some Herculean strength and rallied by about 2.5 percent against the dollar and 2.1 percent against the euro.

This sharp rally was started by dollar weakness. Stop-loss rand buying followed and, hey presto, we closed below R7 to the dollar.

So where to from here? The first thing that jumps out is the expected path for producer price index (PPI). The recent data confirm what we have believed for many months now - that PPI should soon enter an extended period of negative inflation.

We believe that the year-on-year growth in PPI will be negative until mid-2004.

Also, CPIX should be within the target band from September. This adds support for further rates cuts and is very conducive to lower bond yields. 

Last month I argued that by using expected inflation and real interest rates we can make an estimate of fair value for the nominal bond yield. I concluded that 9 percent was a reasonable estimate for fair value on the R153. At the time it was trading around 9.65 percent and has now rallied to 9.15 percent, in line with my expectation. Adjusted for inflation, the R153 yield is around 2.85 percent, some way off our long-term expectation of 5 percent.

As we expect inflation to decline by about 2 percent into early 2004, the inflation-adjusted yield will come close to the 5 percent level. This means that there is not much room for further gains in nominal yields.

However, in the same column it was pointed out that market sentiment can cause the nominal yield to deviate substantially, and for some time, from its fair value.

The question we therefore need to answer is whether market sentiment can remain buoyant over the next few months, taking the R153 yield below 9 percent.

Sentiment will be supported by the declining trend in consumer inflation and the repo rate. Traders will find it cheaper to buy bonds as their funding rate drops with the repo rate.

The strong performance by the currency will add to this buoyant mood. The government's funding programme is progressing very well, meaning that bond supply is unlikely to rock the boat.

However, at this stage our house believes that the US treasury market is too strong and will sell off through to the end of the year. This will dampen the bullish mood to some extent.

The balance of these factors therefore favours bond yields to continue to track lower for the next week or two. But we would recommend caution against buying aggressively at current levels. As the R153 goes below 9 percent, it will be expensive versus fair value.

Leon Myburgh is an interest rate analyst at Barclays Capital

Publisher: Business Report
Source: Business Report
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