By Brian Kantor
Fed chairman Ben Bernanke spoke of a surprisingly promising outlook for the US economy, of 3% to 3.5% growth in 2014 that, if it all materialises as predicted, would allow the Fed to taper off its securities purchase programme from September this year and to close down the purchases by late 2014 (currently of the order of $85bn a month).
The market listened and reacted in ways that were consistent with the prospect of faster growth in the US but they would not have pleased Bernanke. He was at pains to emphasise in his statements how conditional would be the direction of quantitative easing (QE), ie conditional on the actual improvement in the US economy (and the labour market in particular) to keep the market at ease. The severe bond market reactions were not welcome because higher interest rates (especially higher mortgage rates) may threaten the recovery itself.
Longer term interest rates moved sharply higher in reaction to Bernanke and the Fed. By the weekend the 10 year Treasury Bond yielded over 2.5%, compared to about 2% a week before. More economically significant was the move in inflation linked bonds (TIPS). These real yields moved even than did the yields on the vanilla Treasury bonds, from close to zero on 16 June to over half a per cent by the weekend. Higher real rates are consistent with an improving growth outlook, leading to increased demands for capital to invest in real assets. And so the gap between the vanilla yields and the inflation protected variety narrowed to less than 2%.
Bernanke indicated in his press conference that his target for inflation is 2% per annum – anything less in his view represents a deflationary danger for the economy. The market now expects inflation to be dangerously low – implying more, rather than less, monetary easing to come.
The negative reactions of the equity markets to the more promising outlook for the US economy were not as easily explained. The S&P 500 was down by just over 2% in the past week, having been very firm before the Fed statement. Stronger, more normal US growth of the kind the Fed is expecting drives earnings as well as interest rates higher – possibly enough to add rather than detract from the value of equities that remain (in our judgment) still undemandingly valued by the standards of history and the prospects for earnings.
These interest rate developments in the US had severe repercussions for emerging bond markets and emerging currencies, that until recently have been beneficiaries of a search for yield in a world of generally very low yields. Not-so-low yields in the US reversed these flows, leading to pressure on emerging market currencies and yields of all kinds. SA was not spared these withdrawals of cash from high yielding assets, though the rand and the rand bond market did less poorly than many other emerging market currencies and bond markets, subject as they have been, for example in Brazil and Turkey, to violent demonstrations on their streets.
The rand actually gained by a per cent or two against the basket of EM currencies and the Australian dollar in the week ending 21 June. The yields on both long dated conventional RSA bonds and the inflation-linked equivalents rose, though this yield gap widened slightly, offering more compensation for bearing SA inflation risk by the weekend.
The yield gap between RSA rand bond yields and US Treasury bond yields can be regarded as compensation for bearing the risk of the rand depreciating. This yield gap can also be described as break even rand depreciation. If the rand depreciates over time at a faster rate than implied by the difference in interest rates, it would be better to buy US bonds (and vice versa if the rand does better, that is depreciates on average by less than the difference in yields). This yield remained largely unchanged through the past week. While the rand has weakened against the US dollar it is not priced to weaken at a faster rate.
Expectations about the direction of short term interest rates in SA have been revised sharply higher to the disadvantage of all the interest rate sensitive stocks listed on the JSE, the retailers, property companies and banks etc. With a more sharply inclined yield curve the one year RSA rate expected in a year’s time was 5.13% on 30 April. It is now 7.6% (see below):
The state of the SA economy does not justify higher short term rates. The Reserve Bank is predicted to raise them notwithstanding. Our view is that the Reserve Bank will correctly resist raising rates until the SA economy has picked up momentum, rather than slowing down, as it appears to be doing.
The immediate future of the longer term interest rates in SA will take their cue largely from the direction of long term rates in the US. Better economic news emanating from emerging market economies (and China in particular), would also help the rand and the RSA bond market. There would appear to be some chance that the US bond market has over reacted to good news about the US economy – expectations that have still to be fully vindicated. Higher rates will also encourage the Fed to maintain, rather than slow down, the pace of its bond purchases. If so, the past week may well prove a temporary high water market for interest rates in the US and elsewhere.