Falling bond yields tell the real story of inflation outlook - SA in pretty good shape

Thursday's fall in bond yields following the release of the Medium Term Budget Policy Statement, strengthened a downward trend that has been in place since the end of the second quarter. It also confirms that fiscal and monetary policy is on the right track for bringing down inflation, according Martin Jankelowitz, head of markets and economic research at Investment Solutions.

The South African long bond yield has declined sharply since surging in the second quarter. The second quarter was marked by enormous risk aversion, and specifically investors became very nervous about inflation and the current account deficit. On Thursday the yield declined to 8.2% from 8.4% previously.

Jankelowitz says the rationale for the decline was the Medium Term Budget Policy Statement that was very bond market friendly: Budget surplus on the horizon, increased government savings, supportive and coordinating well with monetary policy, disinflationary.

Finance minister Trevor Manuel on Thursday revised the Budget deficit for 2006/07 down to a low 0.4% of GDP compared with 1.5% deficit projected in the February Budget speech. South Africa is also on track for a Budget surplus of 0.5% of GDP for 2007/08, which would be the first Budget surplus for many years.

Jankelowitz says the bond market is confirming a number of things:

1. Its the cycle, stupid

Prevailing inflation pressures are cyclical and not structural. The bond market is telling us that there is NOT a structural problem with the current account, inflationary trends or the rand. The pressures are cyclical and transitory. Sound macroeconomic management will ensure (or facilitate) a navigation through these waters.

2. We are in a lower inflation and interest rate trajectory

South Africa has successfully managed a structural decline to a lower inflation and interest rate trajectory a trajectory that in time will become a given. This structural trajectory does not dismiss the impact of the cycle over the short-term, however.

3. Its a replay of 2002

We are, broadly speaking, seeing a replay of 2002: CPIX inflation rose in 2002 following the rand's weakness in December 2001, but services/administered prices inflation confirmed that disinflation trends were still strongly prevalent. This is what is transpiring right now.

"After an initial spike, bond market yields in 2002 confounded all the cynics and sceptics by coming down sharply during the year as belief in government's inflation targeting credentials was maintained," Jankelowitz points out. "Once again the cynics and sceptics worrying about inflation and rand weakness are out in full force, but what is the bond market doing? Its disagreeing with them again!"

Jankelowitz says if this structural view of the economy was wrong, it would be observed in bond yields which would trading at much higher levels

4. The fundamentals are looking good

South Africa's economic fundamentals are in very good condition. Government debt essentially represents the risk pricing of macroeconomic fundamentals. "This also supports the view that there is no justified reason for the rand to weaken sharply from current levels," says Jankelowitz.

Jankelowitz says the rand is currently at fair value around R7.50 to the US dollar, while fair value for bonds is around 8.5%- not uncomfortably far from current yields. Current bond yields are also supportive of valuations for financial shares.

"In the long-term the rand will reflect macro-economic fundamentals," concludes Jankelowitz. "What the bond market is telling us is that these are in pretty good shape."