SA Fixed Income Quarterly Insights - 1 September 2022

01 September 2022

The first half of 2022 will be remembered as one of the worst on record for global bonds. The market weathered a storm so intense that United States (US) 10-year bonds suffered a decline of more than 11%, the worst first half performance since 1788 when George Washington standing on the balcony of Federal Hall on Wall Street in New York took his oath of office as the first President of the US.

The dual impact of ever surging consumer prices to levels not seen in four decades in the US, Europe and United Kingdom (UK) - together with developed market (DM) central banks attempting to play catch-up to act against runaway inflation unleashed a severe upward march in global bond yields. Major central banks entered the year behind the curve, needing to adjust policy after they were proved to have severely underestimated the velocity of mounting price pressures that already became evident in 2021. Incorrectly mislabelling it as ‘transitory’. This error necessitated central banks to adopt a hastened approach of policy tightening as 2022 got underway, moving in ever larger rate hike increments. With the hiking cycles now well underway and for the US market prices the hiking cycle to be about two-thirds complete, investors, consumers and businesses cannot be faulted for asking if such a blunt tool of hikes can truly solve the inflation problem. If it can restrain demand to bring it back into balance with supply to combat inflation, when it is in fact supply side and fiscal stimulus issues, rather than demand that accounts for the majority of the inflation overshoot.

We have seen the market recognise the increasing need for central banks to frontload policy and still appear fixated on this dynamic with global inflation not having peaked decisively and energy cost pressures still mounting in the Eurozone via spectacular hyperinflationary-like natural gas prices. French one-year baseload electricity prices are now at €1125/MWh (up 10-fold in less than a year) and the German equivalent also gained to a record hitting €1000/MWh. In oil market terms, it’s the equivalent of over $1 600 a barrel. This re-pricing pressure combined with persistent upside surprises in inflation reaching elevated levels at multiples of various central bank mandate targets sent shockwaves through global yield curves in the first half of 2022.

At the same time, we have also seen the changing policy stance of a hawkish Federal Reserve (Fed) and other central bank peers cause tightening of global financial conditions orchestrated by their interest rate hikes and forward guidance to take policy into restrictive territory. Together with the lack of new fiscal policy stimulus after the $1.9 trillion stimulus delivered by the US in March 2021 and slumping consumer sentiment, higher borrowing costs and declining consumer discretionary spending are some of the factors behind the growing concerns about the global growth outlook. Add skyrocketing energy prices in Europe that threaten the closure of certain industries and manufacturing plants, and stress in China’s housing market, the scope for downside economic surprise momentum appears ghastly.

Following the July Fed meeting, it emerged that the US recorded its second consecutive negative real gross domestic product (GDP) growth to put the US in a technical recession. While the Commentariat remains divided on if this is a shallow slowdown that will result in a soft landing or not, we see more signs that a hard landing outcome is the likely base case and assign over a two-thirds probability to this outcome.

This view is informed by a variety of factors and models, with signalling power suggesting rising risks of US recession by early 2023. These are based on leading indicators from housing which is in the early stages of a downturn but traditionally has had high predictive power to lead the US business cycle. Nowcast models, inverted yield curves and the New York Fed Dynamic Stochastic General Equilibrium (DSGE) Model outputs (https://www.newyorkfed.org/research/policy/dsge#/interactive) which we recently examined all point to an abruptly rising probability of a US recession outcome. Investors should be reminded that the final arbiter of US recessions is the National Bureau of Economic Research (NBER). Typically, they only classify a US recession once they see broad-based decline across many sectors of the economy (Chart 1). At the time that they pronounce this, it tends to be of little value to investors which speaks to the importance offorward-looking and positioning portfolios accordingly.

Chart 1

NBER time series that are used for recession dating

The NBER Recession Committee uses six main macroeconomic indicators to assess (ex-post) whether we are in a recession - all shown in chart 1 above. Economic growth has materially slowed down supporting the rising odds of a recession. In addition, the regional Fed manufacturing gauges have come in very weak and are pointing to US ISM Manufacturing moving towards the mid to low 40s (suggesting contraction and recessionary conditions) in the upcoming data releases for the year.

United States housing activity is very important for the business cycle as it is a leveraged sector that accounts for a good proportion of economic activity. Well, the US NAHB Housing Index just recorded its eighth monthly straight decline – the last time it happened was in 2007. The dramatic rise of the US policy rate by 2.5% in the space of only five months has seen the US 30-year mortgage rate more than double since the start of the year. It is already starting to show a slowdown in housing activity, housing demand, and housing inventory for sale is reaching levels consistent with previous economic downturns and ultimately will intensify as Fed delivers further Fed rate hikes. Housing market trends lead economic and labour market cycles by 6-12 months. Right now, the US housing market is signalling unemployment rate will likely be above 6% in 2023; another data point which is inconsistent with a soft landing.

From March to July the Fed has delivered 250 basis points of hikes seen as the expeditious phase of the hiking cycle that took the policy rate to “near neutral” or “near r*”. Risks are firmly skewed to the downside as the market anticipates an additional 125 basis points hike Fed tightening for the next six months to move the Fed funds from just under 2.5% to near 4% (Chart 3).

Chart 2 – US financial conditions have tightened by almost 400 basis points equivalent to 4% Fed Funds by mid-June (despite only 1.75% rate hikes delivered at that stage) posing growth slowdown implications for the US economy

Change in FCI Year to Date basis points
Source: Morgan

Gridlock in Washington which is expected to become a feature if Republicans win the House in the November midterms (Nov 8) will imply any further fiscal stimulus may be delayed as we already contemplate significant negative fiscal impulse this year in the US that could amplify recession risk in the coming quarters into 2023. The knock-on effects of high inflation following the disruption of supply chains and the Ukraine War, skyrocketing energy prices, limited availability and drought in the Europe region have collided in a perfect storm to elevate recession risks even more in that part of the developed world.

Further anecdotal evidence for the American economy is AT&T seeing rising delinquent phone bills, auto repossessions are skyrocketing, and in the US 20 million households have fallen behind on energy bills. Could home mortgages be next? The importance and relevance of the US housing sector in driving the direction of the overall US economy in the coming quarters cannot be overstated and we recommend people to devote a few minutes to look at the US housing video of EPB research that proved insightful to us.

(https://www.youtube.com/watch?app=desktop&v=Z6JBX8Y8XQM)

The G5 Credit impulse has traditionally been a harbinger of booms and recessions, and it has been deteriorating for over 12 months since its 2021 peak and is suggestive of a sharp growth contraction in the coming quarters. Looking more East, the supply chain has been aggressively offshored over the last decade and Asian exports tend to be a good leading indicator of global economic growth. South Korean exports are cooling down significantly and it recalls the adage that when Asia sneezes, the world often catches a cold.

We remind you that of the past 11 Fed tightening cycles since the 1960s, there has been only three soft landings and it is plain to see that the Fed has a very poor track record in engineering soft landings. History proves the opposite as it is notable that the three soft landings have been scenarios that have been due to exogenous factors bailing out the US economy from economic contraction rather than the Fed’s skill to calibrate policy. The 1960s soft landing was because of very strong fiscal spending by then US President Lyndon B. Johnson. The 1980s soft landing was due to Saudi Arabia deciding to pump more oil which caused the oil price to drop almost 40% resulting in a de facto tax cut on the US consumer. The mid-1990s soft landing was a result of a growth dividend coming from the arrival of the internet boom that coincided with the Netscape IPO. Given the current economic headwinds, the question becomes if there can be another exogenous factor not to do with the Fed in the next 12-24 months that can change the direction of travel.

Chart 3

Three soft landings out of eleven tightenings

Source: Pictet Asset Management, Blinder, NBER

During the first six months of this year the tightening of central bank policy has resulted in a $33 trillion decline in global asset values which is equivalent to almost 40% of global GDP. In our view, policymakers are underestimating the impact of this wealth destruction on future spending power in 12-18 months from now if the negative wealth effect is left unattended.

Fed policy action

By the Fed’s own estimates, they calculate that they have raised policy rates now to a level of 2.5% which they regard as a level near neutral policy rate. Given that the Fed has an inflation targeting mandate of averaging inflation near 2% (Flexible Average Inflation Targeting (FAIT)  regime adopted in late 2019), when restated in real terms it is referred to as R-star. This theoretical concept refers to a real policy rate that is neither expansionary nor contractionary when the economy is at full employment. The firm and unambiguous message from Jackson Hole speech by the Chairman, Jerome Powell, was that the Fed intends to raise the policy rate further above this current near neutral rate (into restrictive territory) which is expected to slow the economy and cause a contraction in demand until the Fed is convinced that the job is done to win the inflation battle.

We note that we have observed ever-declining real neutral rates in the US over the past 22 years. Each time the Fed raised rates above this falling choke-off line, we have seen the US 2-year 10-year yield curve slope invert (trade negative <0) which was always followed by the market and or economic events that resulted in the Fed having to change its monetary tightening bias back towards an accommodative stance. Hence implying the Fed is constrained to raise rates too high for financial stability and debt sustainability reasons. Many argue that with US policy rates being so far below current inflation (2.5% policy rate vs 8.5% headline Consumer Price Index (CPI) year-on-year) the Fed will need to raise rates substantially higher above inflation to have anough efficacy. We have observed that the Fed tended to increase rates to tighten the Fed Funds rate by 100-150 basis points above neutral during the Greenspan era and by as much as 200-250 basis points above neutral in the Volcker era.

In our view, there are merits to both arguments, but we recognise that global debt has increased by over $200 trillion since Volcker fought his inflation campaign in the 1970s. The scale of global debt today acts as a boundary condition that we must factor into the modern monetary policy setting equation. In fact, a Morgan Stanley paper last year estimated the US debt sustainability under the assumption of trend US growth near 2% real implies the real economic 10-year rates need to be on average in a range of -0.5 to +0.5% over the coming decade. This suggests US bond yields for 10-year tenor in the 1.5-2% to 2.5-3% range on average if we assume Personal Consumption Expenditure (PCE) inflation in the 2-2.5% range to achieve debt sustainability. Tightening of policy rates to 4-5% would de-anchor and disrupt the debt financing equation mathematics which will be even more if a prolonged economic contraction were to materialise (Chart 4).

If rates rise above a level that is higher than the debt sustainability level that allows sovereigns to continue to service and fund themselves, the global debt markets will simply malfunction with unintended consequences. Besides these boundary conditions that must be factored in, the Fed for one is also operating under second boundary conditions where they will start to face losses on their own balance sheet (TBs, USTs, MBS, etc.) once the Fed policy rate starts moving above 3.4%. We have seen the 3.4% level hold as a ceiling for the majority of the past year and remains to be seen in the coming months if the Fed is able and willing to lift the terminal rate (MSTERM) (peak of the Fed Funds rate in this hiking cycle) to a level that would exceed this threshold and essentially inflict pain on their own asset holdings for extended periods as they allude, they are prepared to do.

Chart 4 – The real Fed Funds target rate (deflated by 5y5y US breakeven inflation) will rise above the choke-off line

How much can Fed drive up rates?

*Deflated by 5-year, 5-year breakeven inflation (core PCE inflation prior to 2000)

Given the deteriorating outlook on our leading indicators suggesting that the US business cycle is in downward momentum and likely to move further south before a bottom can emerge and the sharp degree of financial conditions tightening we have seen from March to June this year, we anticipate that further tightening by the Fed coupled with its planned step-up to quicken and double the pace of its Quantitative tightening (QT) to $95 billion/month from 1 September. We also anticipate global markets to exhibit higher volatility in the coming months into the US elections due to concern over Fed policy error and also to price in higher odds of a recession outcome.

The QT and its relevant impact on markets is a complex one which is still up for debate and even by Fed’s own admission it has large uncertainties about its effects. The Federal Reserve Bank of Atlanta published a paper where they examine the question of how to quantify the equivalence between interest rate hikes and QT. Using a simple "preferred habit" model they estimated that a $2.2 trillion passive roll-off of nominal Treasury securities from the Fed’s balance sheet over three years is equivalent to an increase of 29 basis points in the current federal funds rate at normal times, but 74 basis points during turbulent periods.

(https://www.atlantafed.org/research/publications/policy-hub/2022/07/14/11--how-many-rate-hikes-does-quantitative-tightening-equal.aspx)

We can therefore surmise that QT is likely to further tighten financial conditions via the liquidity channel. And it can approximate its impact in terms of the degree of tightening via the Atlanta Fed paper that will add to the current Fed terminal rate (rate at which Fed hiking cycle will peak) pricing that is standing near 3.9% by quarter two of 2023. The QT impact to forecast in advance is complex since we don’t know if the liquidity withdrawal will come from the Reverse Repo Facility of the Fed (ON RRP) or from the banking system (bank reserves) or both. Generally, if ON RRP facility increases and bank reserves fall it would signal the fastest liquidity tightening dynamics. Money flowing into ON RRP typically is money that is also drained from banking sector liquidity that lowers bank reserves in the system which could have adverse implications for financial intermediaries or real economy agents that are reliant on this liquidity that may become scarcer.

We have noted that Senior Loan Officer Survey in the US in recent weeks has shifted meaningfully, revealing that US banks are tightening lending standards onshore which will have a negative transmission effect on future US credit growth. The speed of the liquidity withdrawal could ultimately impact markets and tighten financial conditions if bank reserves fall too low. Generally, QT is thought of as increasing the supply of US bonds (USTs) and MBS that the private sector must absorb, which if demand stays constant and other supply from US Treasury doesn’t decrease, is thought of to increase US bond yields and  term premium in US yield curve.

On one UST 10-year yield, Fair Value model QT is modelled by taking the size of the Fed balance sheet into account. The smaller and faster the decline the quicker the additional increase in yields. As a rule of thumb, if the Fed balance sheet drops say $1.2 trillion over the next 12 months as per Fed plans ($95 billion/month pace) then , in theory, it increases the UST 10-year bond yield by 27 basis points. But this is debatable as not all agree on this relationship. Under quantitative easing periods, long-end yields were observed to rise as expectations for growth pick up while the reverse is true during periods of financial policy tightening that impinges on the growth outlook.

The conflicting forces of weaker growth and higher inflation as well as questions as to how the Fed’s reaction function will evolve make for a highly uncertain environment, marked by low conviction and consequently weak risk appetite and high volatility. Hence it is easily appreciated why the MOVE Index this year has remained at historic highs while equity implied Vols have been more benign.

With the risk of economic recessions becoming a reality, inflation may remain above target due to supply side factors. Lagging economic indicators could make for a policy bind by central banks as we enter 2023. This may even lead to a discussion of central bank mandates needing to make provision for inflation targets that allow for a higher level of inflation that has characterised the last 30 years. In the UK, the Prime Minister (PM) candidate in the running, Liz Truss may ask the Bank of England (BoE) to abandon its 2% inflation target in favour of boosting the economy if she becomes PM. An article in the Telegraph a few weeks ago suggested that a discussion between Truss and the BoE Governor Bailey has occurred already in which BoE expressed openness to consider potential changes which is something that bears close watching for future policy landscape globally. Equally interesting was a Jackson Hole academic paper presented by Harvard Professor Furman who says Fed should raise its inflation goal and declare victory against inflation at 3%.

At the Jackson Hole Symposium, upcoming global markets were looking at this event for Fed Chair to provide more forward guidance to markets about the path of Fed policy now that they have hiked rates closer to neutral as to how they think about additional tightening steps. How much more the Fed could tighten policy without causing major liquidity issues in US dollar markets and USD appreciation is still an open question. Interest rate derivative markets have been pricing in doubt over the Fed's resolve, which stands to reason when considering the speed of the slowdown in US housing market activity in recent months while CPI inflation appears to be topping out. The December 2023 Fed funds future is pricing rates around 3.5% – roughly 100 basis points higher than the current rate (Chart 3).

Chart 5

Fed rate cuts being priced in for 2023 does not necessarily mean the market is implying that it's the most likely outcome/path; it's merely the residual of market participants' probability-adjusted reward-to-risk bets on Fed rate cuts in a potential coming recession.

Source: Bloomberg

The inflation conundrum

A re-opening of the post lockdown economy that brought pent-up demand, coupled with supply chain bottlenecks and disruptions, a fiscal stimulus largesse of helicopter money to US households that was further exacerbated by the Ukraine and Russia war, have all conspired to send inflation to astounding levels most of us have not seen in our careers. This raises the question of how should central banks and governments respond and if aggressive rate hikes are appropriate policies that may be impotent to alleviate inflation that is supply side driven rather than demand side.

The New York Fed published an article tackling this very question, and their answer is that roughly 60% of the CPI increase was demand-driven. Supply constraints compounded the issue which we argue would have been far less of a factor had it not been for $5 trillion of fiscal stimulus during the Covid-19 pandemic. In a recent interview, Prof Joseph Stiglitz said that raising interest rates doesn’t solve the supply-side problems. He said, “It can even make it worse because what we want to do right now is invest more in the supply-side bottlenecks but raising interest rates makes it more difficult to make those investments”.

The US inflation is in process of peaking in our view on a headline level and is expected to fall in the coming quarters. This is informed by our view that lower disposable income will help reduce demand. Moreover, base effects will begin to weigh as we get into quarter two of next year when comparatives measure price shocks that occurred when the Ukraine invasion happened this year in late February. Also, several indicators that have had historic predictive values for US inflation suggest we are at a peak in US inflation and likely to decline. According to Alpine Macro, their work suggested a larger role of the supply side factors vs the Fed study. They found that the current US inflation phenomenon is likely 70% supply (bottlenecks, shortages, labour market disruption) and 30% demand-driven (fiscal and monetary stimulus). Now, oil and food prices, inflation breakeven rates, and the backlog of orders and delivery times are all falling.

The CRB, Harpex, and Baltic Dry shipping indices are three variables that explain supply-driven inflation well. All are headed lower. The resolution of supply bottlenecks is equivalent to an outward shift in the aggregate supply curve, which is a disinflationary, pro-growth scenario (bullish for risk assets). The PCE inflation is forecasted to start to decline in quarter four of 2022, a trend that will accelerate in 2023. Aggregate demand is weakening – the GDP of the first half of 2022 was negative and real final sales are not growing.

Meanwhile, supply constraints are easing. Shelter inflation (including rental inflation) is likely to drop quickly as the housing market cools in response to higher mortgage rates. Moreover, the strong USD mutes import price inflation. While we know there will be sticky components in the inflation basket that will take some time to moderate, we are seeing several signs of inflation outlook improving in indicators such as prices paid subcomponent indices, improvement in shipping rates, lower commodity prices, and signs of even demand destruction such as what has become evident in US Summer driving season to name only a few. Of all the inflation cycles during recession times in the US when US inflation exceeded 5%, we saw that on average it took around 16 months for inflation to return to the 2% mark.

For now, the so-called Fed pivot trade that followed the market optimism that the Fed may have room to slow its hiking pace post the July Federal Open Market Committee (FOMC) meeting is unwinding. It is just a scary CPI print away from being a head fake that results in a fresh selloff after a tactical countertrend rally for emerging markets (EM) and risk assets. We prefer to maintain a defensive bias and have a long USD and bearish on EM currencies view and recommend underweight exposure to BB or weak credits. We think that the market still needs to work through another bout of volatility related to external factors, including pricing a more hawkish Fed, before the path is clear to a sustained recovery in spreads. Only signs of a much stronger growth rebound in EM would offset the negative impact of tighter global financial conditions, and this is not happening so far, meaning the correlation to US credit spreads should remain high.

Jackson Hole paper by Bianchi and Melosi of Chicago Fed and John Hopkins University found that approximately half of inflationary pressure was rooted in fiscal policy and that Fed won’t be able to curb inflationary pressures as monetary policy alone may not prove an effective response if inflation has a fiscal nature.

History tells us that the Fed never stops hiking rates until the nominal policy rate (Fed Funds) exceeded PCE inflation in any of its cycles. Based on Chair Powell’s speech at Jackson Hole, which was short and clear, the Fed is fully committed to tighten into restrictive territory and keep rates high until they are convinced that the job is done to win the battle again inflation, we have to expect this time to not be different. This pushes back hard against the idea or views of a pivot in late 2022 or very early 2023. If we look at current Fed Funds pricing and current inflation pricing for US inflation (US CPI fixings for 2023) and US 1-year inflation swap (trading near 3.05%) suggests to the US that this condition may only be met by the middle of 2023.

It would therefore likely require other issues such as market malfunctioning due to funding liquidity drying up, credit spreads blowing up that cause refinancing issues for corporates, defaults, stock market or banking system stress to bring forward an earlier pivot (one where Fed changes policy path setting even if inflation objectives are not yet achieved in full) by the Fed.

Given our assessment, the economic conditions are weakening and likely to intensify. This being amplified by the Fed tightening earlier this year starting to take effect (with a lag) and additional upcoming hikes, severe pressure on European and China as trading partners we see heightened risk. This heightened risk that both the Fed and other central banks are presented with a situation where they are faced with a choice between a very painful trade-off between growth and inflation and where they will most likely have to choose to adopt a policy setting that allows for higher (than current inflation targets e.g. Fed prepared to live with PCE at 3%+ vs 2% average inflation target). We expect this to become an emerging theme next year and a hotly debated topic by academics, governments, and central banks. In fact, we already know discussions have occurred between BoE Bailey, US Treasurer and Lis Truss if successful to become the next UK PM has already communicated her intention to ask the BoE to consider raising its inflation target. We also noticed that a similar proposal was made for the US policy setting from one of the academic papers at Jackson Hole.

We expect the GDP retrenchment, weakening of labour markets, contracting liquidity that is being accelerated by Fed QT and tightening of financial conditions driven by higher oil prices, rampant dollar acceleration, widening credit spreads and falling equity prices and higher short-term rates to all conspire and bring a Fed pivot/pause in its hiking cycle.

We caution against the view held by some of our competitors that we have weathered the storm and that the next six months are likely to be better than the past six months. We think this view is underestimating the market repricing that can and has to happen for risk assets to reflect the economic risks cited above. And that the economic pain will have to reach a level that is unbearable that ultimately forces a very strong monetary policy response to ease conditions again that alters the investment landscape that creates optimism and true impetus for a new business cycle and economic upswing to occur. Given the risk that inflation may prove ‘sticky’ and not decelerate from current high levels at a fast pace tied with the Fed’s intentions not to commit another policy mistake after starting to remove accommodation too late in the cycle suggest the fed is fearful of pausing too early and may overdo its policy tightening. This may well mean that they adopt the approach of the Volcker Fed that tightened the Fed Funds rate by 200-250 basis points above neutral. This would mean the possibility that the Fed Funds rate must rise to between 4.5-5% (as opposed to the current peak of 3.8% priced). We think this risk is still underappreciated by the market and could see US 2-year rates trade close to 4%, but we expect curve inversion of almost 100 basis points to US 10-year suggesting the 10-year yields may be trapped near 3-3.25% area until the hiking cycle is fully mature, and a true Fed policy shift becomes evident.

Chart 6 - US CPI fixings indicate US headline inflation could decline to 3.7% by May 2023 and US PCE closer to 3% by May/June 2023

Source: Bloomberg

The rand

We have a bifurcated view on ZAR. We think that in the coming months USD strength is likely to prevail on the back of relative central bank balance sheet trends of Fed vs ECB, BoE and rest of G4, US economic growth differential staying wide to DM and the Fed maintaining a hawkish stance to continue to tighten policy. We see scope for risk around European growth pressures emerging later in the year when European winter arrives on the back of negative impacts of energy supply and energy prices which is likely to support a safe haven bid for USD. Our base case as mentioned is ultimately for the US growth picture to also deteriorate and see a larger than two thirds probability that the US could move from a technical recession now towards a hard landing scenario where it meets the NBER classification of a formal recession where there is a broad-based downturn in many sectors of the economy.

In the near term, we remain negative ZAR on technical factors surrounding the South African Reserve Bank (SARB) Monetary Policy Implementation Framework which involves moving to a surplus in September and also involves the unwinding of the SARB forward book and FX swaps. This is likely to compress ZAR FX implied yields and also ZAR xccy swap rates lower which is expected to weigh on the rand. The rand carry per unit of volatility is poor versus its Latam peers that have posted aggressive hikes. The rand is also at risk of seeing depreciating pressures from the threats of the Financial Action Task Force greylisting decision on South Africa that can hamper capital flows in addition, the liberalisation of Reg 28 offshore limits earlier this year post February budget could result in more utilisation of local fund managers to externalise assets, which is already evident in quarter two of the Association for Savings and Investment South Africa data. These are some of the factors keeping us to retain our underweight stance on ZAR (we turned UW post Easter break in April 2022) and advocated to utilise it as a hedge/overlay against long South African Government Bond (SAGB) positions which we intend to keep until the broad USD turn is evident and/or South Africa (SA) idiosyncratic risks improve.

The US earnings outlook for corporate profits picture is likely to deteriorate later this year and this should bring renewed downside pressure on US equities which will be risk sentiment negative and should have a similar negative spillover for ZAR that often moves with waxing and waning of broader global risk sentiment. Our base case is for USDZAR to move closer to or above the 18.00 (extreme peaks) model which incorporates large ZAR deviations from its longer-term fair-value trend during periods of US recessionary scenarios, whereafter we see ZAR appreciation with USDZAR returning closer to the 15.50-16.38 range. This will happen once the Fed has changed direction in 2023 to either pause its hiking cycle or deliver rate cuts that can provide the stimulus that can allow the US economy to start to recover.

We see this transition taking anything from two to five quarters. We believe the current Fed (having low credibility after the policy mistakes of classifying inflation) as transitory and running with ultra-easy policies too long by keeping rates near 0% would seek to err on the side of caution to rather be remembered as the New Paul Volcker Fed rather than the New Arthur Burns Fed which increases the risk of overtightening.

China has been back in the headlines in August on geopolitical tensions following Nancy Pelosi visit to Taiwan. But the broader impact on EM fixed income from China's slowing economy and property stress has been largely relegated to an afterthought for markets this year given the focus on the Fed, global inflation, and the fall-out from the Russia and Ukraine war. But this does not mean it should be ignored. Housing data from China continues to point to the market weighing on China’s growth outlook. Recent easing steps by People’s Bank of China to cut policy rates and support packages for property development sector has started to weigh on the Chinese Yuan. For the first time in the modern era, Chinese policy rates are now below US policy rates. Given the current Fed tightening bias, easing bias and growth risks of China we can anticipate seeing USDCNH trade higher which is a trade we have looked at since early August. Given the high sensitivity of ZAR to CNH moves and SA export dependence on China with China making up 10% of SA exports, we should expect the USDZAR path of least resistance to be higher

This leads us to maintain our long USDZAR view which we have been advocating since mid-April near 14.65. We continue to view long SAGB with long USDZAR hedge and overweight SA Linkers as a strategic asset allocation setting which we adopted post Ukraine invasion by Russia in late February which informed our view that stagflation risk is likely to mount and resulted in us adopting a more defensive positioning.

SA bonds

The SA inflation is likely to stay elevated with the disinflationary trend only starting only in quarter two of 2023 is a headwind for SA bonds. We see some fiscal risks but wouldn’t classify it as elevated as there appears to be large cash buffers and strong Corporate Income Tax trends persist which can allow National Treasury to deliver on a tighter budget deficit than projected in February. Uncertainty exists over how the market will receive the Eskom debt announcement that will see a large portion of Eskom debt migrate onto the sovereign balance sheet with details due for announcement at Mid Term Budget Policy Statement. We do not see it as a risk factor for SA debt rating downgrades and if well structured, it could even engender positive rating comments if it is seen to lower the overall government’s burden from a debt servicing cost standpoint. Until recently we were looking for a potential cut in ILB and SAGB auction sizes later this year, but our latest thinking is that NT may decide to be conservative and use the current fiscal outperformance to offset fiscal detractors such as higher civil wage bill settlements and large R197 redemption due next year of over R100 billion by pre-funding these items.

Given that the local inflation picture is unlikely to improve until mid quarter two of 2023 and also in face of SARB hiking cycle that is likely to run well into the first half of 2023 before SARB opts to pause doesn’t provide any major bullish catalysts for SAGBs against the negative EM backdrop. Swing factors for us would be if EM risk appetite improves should USD start to weaken if the Fed is closer to announcing a pivot in its policy setting which would bring a swift change in fortunes for EM Debt and EMFX which will bring a much rosier outlook for SAGBs and ZAR once we reach this important market juncture.

The next few months will continue to be challenging to navigate given the ANC elective conference at the end of the year where President Cyril Ramaphosa will be up against contenders for a second term. The market may remain somewhat nervous into this conference which is scheduled to occur from 16-20 December 2022. We would therefore be surprised if the market doesn’t build in some risk premium ahead of this event which could also happen as political headlines become more frequent leading into the event such as the recent announcement of a vote of no confidence in President Ramaphosa surrounding questions and investigations into events at his Phala Phala game farm.

In the absence of large unforeseen negative surprises on the fiscal front or strong deterioration in risk or big increases in US 10-year and longer TIPS real yields, we do not anticipate the SA curve to steepen significantly. In fact, we expect relatively docile markets, stable VIX and large month end coupons in August to help SA curve long and ultra long bonds to flatten into early September. Once into the final quarter of 2022, we expect volatility to pick up into the Fed September’s FOMC when Fed is likely to raise rates again by 75 basis points to take the policy rate to above 3% and move to a monthly QT cap of $95 billion. These moves in our view will further tighten financial conditions in the US to more inverted US yield curves, strengthen the USD, widen credit spreads, weigh on EM, lead to a renewed selloff in the US, global equities and could start to usher in market functioning and financial stability risks that Fed will have to contend with. If this plays out in line with our expectation, we expect to see SAGB curve steepening occur during the late quarter three into quarter four if the heightened risk backdrop unfolds.

The evolving landscape and positioning – will the Fed blink?

Given the plethora of risks that remain with tensions between Fed policy intentions to continue to hike and the market that is pricing frontloading of Fed hikes flowed by Fed rate cuts in the second half of 2023, there are sufficient reasons to be cautious in portfolio positioning. Fixed income markets may be required to re-price towards the hawkish Fed as opposed to the Fed that has to capitulate and move towards expressing that financial stability and backstopping the business cycle demise takes precedence over inflation concerns.

We do believe a Fed pivot will be forthcoming but timing is hard to judge given the resolute language of the Fed and the unlikelihood of inflation criteria being achieved before mid-2023. But one indicator we have looked at offers a different perspective that springs some hope for investors looking for the end of one of the second longest EM bear market over the past 25 years.

Along these lines, we note the below chart which shows the US 2-year 10-year swap curve versus the US two-year 20-year swap curve for the two-year forward point for each of these swaps. The below chart was used in early 2022 by us to inform us to anticipate that US yield curves likely to flatten hard when the curve was near 60 basis points based on the 90-day lead relationship of the 2s10s forward curve. Note that the 2s 10s forward curve has proved prescient calling past 2s10s curve moves and was correct calling US2s10s curve to flatten and invert a position that we advocated in January 2022. 

This worked remarkably well with the US 2s10s curve inverting and currently trading at its most inverted level on record at -62. The forward curve, however, has returned to be upward sloping (after inverting before the 2s10s curve) near 20. The forward curve has moved up by over 60 basis points and leads by three months suggesting to us that post US elections around the time of the November FOMC meeting or just after in the run-up to the December FOMC meeting the Fed may pause in its hiking cycle or even contemplate moving to an easing stance if the forward curve continues to have predictive power. Should this transpire, we are likely to see the US 2s10s curve moving back steeper into positive territory which will occur once we move into a bull steepener. This tends to happen once the market signals confidence that the hiking cycle is mature and that the next policy moves are for Fed to start cutting rates. The lead relationship of the forward curve could contain a hint to us that the so-called ‘Fed pivot’ may in fact be possible in the latter half of quarter four of 2022.

If this is indeed the case, we will need to also pivot our portfolios to benefit from the maturity of the Fed hiking cycle that will usher in a weaker USD and provide room for EM Debt markets to recover in 2023. This coupled with disinflation and local SARB rate hikes to peak next year is likely to drive positive returns for SAGBs next year which will allow us to extend SAGB duration and also remove our long USDZAR hedge that is currently used as portfolio overlay long SAGBs together with removing our overweight in inflation linkers.

Chart 7 – US 2y10y swap curve (yellow) and US 2y forward US 2y10y swap curve (white) leading by about 90 days.

Source: Bloomberg