Still sliding consumer inflation, stress tests and interest rates ….

Erik Nel, an analyst from Atlantic Asset Management writes that we have had another turbulent week both globally and locally, with European bank stress tests on the surface failing to address the deeper underlying (sovereign issues). Onshore we experienced a further massive influx of capital from the foreign contingent, while macro data at the margin seems to be slightly contradictory to the SARB MPC’s decision to leave the repo rate unchanged.

In this regard the market now appears content to almost fully price the risk of a September interest rate cut, despite the governor making it very clear that the hurdle for further cuts is now very high. In particular it was talk around their unhappiness with the level and volatility of the Rand that caught our attention.

Working through the logic around leaving rates unchanged (against a backdrop of still sliding cyclical consumer inflation) it is worth noting that the SARB appears content to rather use taxpayer money to weaken the Rand than it is to inject further monetary relief – and in the process going one word short of claiming that it has done as much as it can up to this point and that fiscal authorities now also need to come to the party. (Their point gained some credence when we received unemployment data for Q2 yesterday). Clearly the SARB does not want to cut rates further if they had any choice.

Expect the market to remain in washing machine mode for some time to come (August/September is historically speaking a volatile period on markets), while foreigners should continue to find value in the local market given global authorities’ reluctance to take away the punchbowl, and in the process guaranteeing record-low interest rates.

Fixed Income

Foreigners continue to rule the roost in the local rates market, with net purchases for the month clocking just shy of a record-breaking R20bn. The feedback we are receiving from the market-making community is that foreign leveraged money is taking some profit as bonds are trading on critical resistance, but that they continue to see new, large, global real money names almost on a daily basis entering the local bond market.  It would appear comments made earlier in the year by some of the large global banks that South Africa as a local debt asset class was under-owned by the offshore contingent is proving to be to correct.

In recent weeks we’ve had at least three sell-side strategists putting a buy (with a downside target of at least 8.00%) on the 10-year government bond, which at current levels imply a further 25bp downside risk in rates. Our take remains that authorities appear reluctant to cut rates further – a decision we fully agree with – and that it would be an interest rate cut only that should sustainably allow bonds to rally towards 8.00%.

We do acknowledge though that material upside risk for rates have decreased substantially as we’ve clearly moved into a new trading range since the start of July, perhaps in large part thanks to Fed governor Bernanke’s comments that the economic outlook is ‘unusually uncertain’.  With the September MPC meeting still some way off, and some key data releases expected between now and then (July inflation, Q2 GDP, PMI, manufacturing production, retail sales), we may be in for a volatile period and expect the Rand to dictate proceedings to a large extent.

 Figure 1: R207 – Foreign demand and local strategists still looking for further downside

Fixed Income

While the market appears to have taken the outcome of the European bank stress tests in its stride (the S&P 500 clearly rejecting the death cross signal at 1,040) to slice through the key 1,100 level once again, we feel that authorities missed a crucial opportunity to allay market fears with regards to sovereign risks. Clearly the stress tests were conducted in a much smaller way than anticipated, leaving many questions unanswered.

With uncertainty then still remaining with regards to the health of European sovereigns, and Bernanke seemingly very worried about the economic recovery, we remain in a very fragile world. US housing data of late confirms our long-held view that it is going to take a very long time for this large part of the economy to be fixed, and authorities have no choice but to adhere to the cries and continue to provide relief for as long as is necessary in order to guarantee the recovery.

Meanwhile distortions will continue to grow bigger as fiscal risks remain on the increase and easy policy and record-low interest rates stand the risk of creating pockets of asset bubbles – some of which are already apparent in emerging markets in particular. While inflation still seems some way off, this Piper will have to be paid at some stage.

Foreign Exchange

The Rand must be starting to work on the SARB’s nerves as it seems the more aggressive their rhetoric about it becomes the harder the unit rallies. With the trade-weighted Rand now firmly above levels preceding the March MPC and CPI since the decision sliding to 4.2% (and some still fearing a break below 4% in coming months) the SARB clearly has its work cut out.

Perhaps they should take heed from the Harvard Group and OECD comments that cost of intervening will be far exceeded by the cost of not intervening.  While trading close to the bottom-end of its long-held range the Rand is dangerously close to a big break on the downside and will need to hold current levels and preferably break back into the mid 7.40s in order to reject an eventual downside test of the 7.20 level.