What can we expect in a rising interest rate environment?

At the Monetary Policy Committee (MPC) meeting of the South African Reserve Bank in January this year, the MPC surprised the market by hiking interest rates by 50 basis points, a decision that was not generally expected, especially so early in the year.

Generally, within the fixed universe of investment options, bonds tend to be the least preferred destination when rates rise as bond yields move in line with the rate hiking cycle (see chart 1).

Looking at different options

It is important to consider a few options when deciding on whether bonds will underperform further if interest rates continue to be hiked, two of which are considered here.

First, the bond market tends to either lead or lag the move in interest rates. In the current cycle, chart 1 illustrates that the market was anticipating the hiking cycle and sold off in advance of the first rate hike (see circled area in chart 1). We therefore need to evaluate whether the size of the selloff has been sufficient in terms of what is already priced into the bond market.

Chart 1: SA 10-year bond vs. repo rate (%)

Source: I-Net

The MPC has highlighted on a number of occasions that it is concerned about growth in South Africa and takes this into account in its flexible inflation targeting mandate. This suggests that the magnitude of the current cycle could be less pronounced given how constrained growth is domestically. The selloff in bonds that has occurred may therefore be sufficient and, if bond yields do stabilise, their higher running yield relative to cash should result in bonds beginning to improve performance relative to cash once again. This scenario assumes, however, that the amount of rate hikes already priced in is sufficient, which may be too early a call to make at this stage.

However, a second consideration must also be explored: what the level of real rates in the market currently is. For example, is the available yield above, or below, inflation?

Real rates on 10-year bonds are currently around 2.3%, while money market real rates are marginally negative. We think fair value for real rates in the long term is around 2.5% to 3% for an economy like South Africa, which is a function of the term premium and inflation expectations over the medium term, while money market real rates need to be positive.

Hence bonds still having room to selloff further to restore fair value from a real rate perspective.

Looking forward to uncertainty

Looking ahead, we are entering an uncertain environment with the US Federal Reserve pushing ahead with tapering and normalising policy in the US through hiking interest rates if the growth environment in that country allows. Growth in China has also been slowing, with adverse effects on commodity prices being experienced as a result.

These issues have implications for emerging markets, especially those with commodity export economies running twin deficits, with a large reliance on foreign flows to finance these deficits. These economies will still have to go through some form of rebalancing given the misallocation of resources over the past roughly five years.

South Africa, with its twin deficits, labour pressures, and heavy reliance on foreign inflows, could come under pressure in this scenario, which has negative implications for the rand and inflation.

Money market and credit assets, with the consistent running yield they offer in a reduced risk taking and defensive fashion, should therefore be high on the fixed-income investor’s radar if conviction levels are low.