Interest rates and the battle of stagflation
No central banker, especially one who has inflation targeting as its main objective, ever likes to hear the word stagflation. This is unfortunately the harsh reality currently facing the South African economy. The latest CPI inflation release is above the 6% target limit, and the most recent GDP data has shown that the economy contracted by 0.6% in the first quarter of 2014. This is the worst position for any central banker, as raising interest rates should successfully contain inflation but at the cost of potentially throwing the economy into a recession. On the other hand, by cutting interest rates and stimulating the fragile SA consumer, the South African Reserve Bank (SARB) should succeed in reviving the growth outlook, but at the even greater cost of letting inflation spiral out of control. It should, therefore, come as no surprise that the SARB has decided not to adjust the repo rate at its last two meetings.
So what happened in January this year, one might rightfully ask? Why did the SARB opt to hike the repo rate by 50 basis points to 5.5%? One could argue that the international landscape at the time looked somewhat different to what it is now. The rand had depreciated to R11.30/USD, foreigners were large net sellers of local SA bonds and other Emerging Markets (EM’s) were hiking their policy rates to remain attractive to foreign investors. All these factors left SA somewhat vulnerable, and probably forced the SARB’s hand in raising rates, although it justified this action by projecting much higher inflation expectations. Add to this SA’s 'twin' deficits, which rely on foreign currency inflows for funding, and you get a deadly cocktail if interest rates are not raised. So, the hike steadied the ship again and bought the country some time. Luckily, the international landscape has changed from January and it seems as if the global hunt for yield is back in play. How long this situation will last is a very difficult question to answer. As long as global liquidity remains elevated, GDP growth continues to recover fairly slowly and global inflation and volatility remain low, this trend can last for a few months longer, but certainly not forever.
Although the SARB kept rates unchanged at their last two meetings, they have continuously cautioned the market that in terms of monetary policy, the economy is in the midst of a rate hiking cycle. Why then, given that growth is so weak would Governor Jill Marcus warn us of this? The large current-account deficit is probably one reason. The depreciation in the rand exchange rate should have made our exports more competitive relative to our imports and thereby reduce this deficit. So far, this has not happened and the trade balance has been very slow to adjust (not helped by the mining strikes) and it would take higher interest rates to stave off imports which have largely been driven by consumer spending. Furthermore, with the repo rate currently at 5.5% and inflation above 6%, SA is one of only a few EM’s with negative real rates. To be more competitive in the hunt for foreign capital, the country would need to offer higher real yields to attract foreign investors. Not being able to fund our deficits through foreign investments would add further pressure to the currency which in turn would push inflation even higher.
How high can the Repo rate go? Current market expectations are for the Repo rate to increase to between 6.5 – 7.5% in two years’ time. Previous hiking cycles in South Africa have typically been between 400 and 500 basis points (9.5% to 13.5% in 2002 and 7% to 12 % in 2007/8). We expect that this time around the cycle might be relatively shallower than these previous ranges. There is a widely held view that the neutral Fed Funds rate has established a much lower range now than the prior 4% level before the Global Financial Crisis. Current market expectations for the Fed Funds rate are at less than 2% in two years’ time, confirming the perception that the normalisation process would take time. Likewise, taking the lacklustre growth situation in South Africa into account, it could easily be argued that a SA Repo rate closer to 6.5% - 7.0% would be considered as neutral in this hiking cycle. The lower neutral SA Repo rate could also have an impact on the 10-year bond yield.
The extract below from the latest SARB’s bi-annual Monetary Policy Review best describes their current stance:
“The world economy is back in the start phase of what has been a stop-start recovery, as the Fed has started tapering its extraordinary stimulus measures. As a consequence, international capital flows have become more erratic, creating new pressures on emerging markets. Monetary policy is in a rising interest rate cycle and will align to the speed of global policy normalisation. It will do so, however, within a flexible inflation-targeting framework that allows MPC decisions to remain sensitive to changing data and the fragility of the domestic recovery.”
Globally, economists are fairly optimistic on the outlook for US growth, and inflation appears to have bottomed. The US Quantitative Easing (QE) stimulus program should end in October this year if the Fed continues to taper at the current pace of $10 billion per meeting. This reduction in liquidity would not be positive for EM interest rates, and should place pressure on real rates in these countries. Other countries like Europe and Japan are however still stimulating their economies with various forms of stimulus as they continue to battle deflationary or growth fears. It is for this reason that US10-year rates have remained stubbornly lower than expected in recent months, but this pressure should abate as the US economy and inflation rates start to normalise in the second half of 2014.
We continue to remain underweight fixed income as an asset class and would begin to reduce our underweight position as 10-year bond yields rise to our fair value forecast of about 8.75%. Further supporting our underweight position is the subdued total return expectation of 4% to 6 % from this asset class over the next 12 months. However, given the expectation that the current interest rate hiking cycle might well be shallower than previous hiking cycles, we would warn against being too pessimistic on this asset class over the medium term.
