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South African Linker Rally of the Century Seen Fizzling

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South African Reserve Bank Deputy Governor Daniel Mminele
Daniel Mminele, deputy governor of the South African Reserve Bank. Rates will need to rise again to curb “uncomfortably high” inflation, with risks “tilted to the upside,” Mminele said on June 25. Photographer: Ian Waldie/Bloomberg

July 4 (Bloomberg) -- Investors who drove South Africa’s inflation-linked bonds to their best quarterly performance since at least 2000 say consumer-price growth has probably peaked.

So-called linkers returned 8.5 percent in the three months through June, the most since Bank of America Merrill Lynch indexes started tracking the securities in 2000, and beating gains on the nation’s fixed-rate bonds and equities. Inflation-protected debt in emerging-market governments gained 6.6 percent on average in the period.

While the South African Reserve Bank has held off raising interest rates since January as the economy slowed, policy makers may need to act this month after inflation hit a five-year high in May, said Michael Grobler, a money manager at Atlantic Asset Management. That would help slow consumer-price growth and draw investors to the higher real yields on fixed-rate bonds, he said.

“I’d be surprised if they outperform again in the third quarter,” Grobler, who helps manage the equivalent of about $371 million in fixed-income assets, including inflation-linked debt at Atlantic, said by phone from Cape Town yesterday. “I would lean towards committing new money to nominal bonds.”

Policy Dilemma

South Africa is sold 800 million rand ($74 million) of inflation-linked bonds maturing in 2022, 2038 and 2050 at a weekly Treasury auction today. Investors bid for 1.2 billion rand of debt, down from 1.42 billion rand at the previous auction on June 27.

Yields on the 2022 linkers fell 13 basis points to 1.64 percent since the start of the second quarter. Inflation-linked bonds pay interest adjusted monthly for changes in the consumer-price index. Real yields are returns adjusting for inflation.

South Africa’s central bank is facing inflation exceeding its 3 percent to 6 percent target, while the economy contracted in the three months through March. The bank’s monetary policy committee left the benchmark repurchase rate unchanged at 5.5 percent at its last two meetings, after an unexpected increase of 50 basis points in January.

Rates will need to rise again to curb “uncomfortably high” inflation, with risks “tilted to the upside,” Reserve Bank Deputy Governor Daniel Mminele said on June 25. The acceleration to 6.6 percent in May exceeded expectations and inflation may remain outside the target for an extended period because of the rand’s depreciation, he said.

The rand has declined 6 percent against the dollar over the past 12 months.

Inflation Peak

Forward-rate agreements, used to speculate on interest rates, are trading 30 basis points above the three-month Johannesburg Interbank Agreed Rate before the next MPC meeting on July 17.

The central bank on May 22 projected inflation would peak at 6.5 percent in the fourth quarter.

“The longer-term outlook for inflation doesn’t look that bad,” Mokgatla Madisha, who helps manage the equivalent of about $1.7 billion at Argon Asset Management in Cape Town, said by phone yesterday. “We’re about to peak, if we haven’t peaked already.”

Should inflation start to moderate, fixed-rate bonds would be a better bet than linkers, he said.

Currency Question

Investor inflation expectations for the next five years, as measured by the yield difference between index-linked and fixed-rate bonds, known as the break-even rate, climbed 42 basis points to 6.69 percentage points from this year’s low in May. That may narrow if the central bank raises rates and inflation moderates, said Jean-Pierre du Plessis, a strategist at Cape Town-based Prescient Investment Management, which oversees the equivalent of about $8.3 billion.

The economy contracted an annualized 0.6 percent in the three months through March as mining output plunged during a five-month platinum-industry strike. South Africa will probably miss its 2.7 percent growth forecast for 2014, Finance Minister Nhlanhla Nene said on July 1.

The rand weakened 0.1 percent to 10.7576 per dollar by 5 p.m. in Johannesburg. It’s the worst performer among 16 major currencies tracked by Bloomberg over the past year.

“There’s going to be some moderation in inflation after the next two quarters, but the million-dollar question remains what is going to happen to the rand,” Du Plessis said by phone yesterday. If the rand extends its slide, that may fuel price increases and demand for linkers, he said.

To contact the reporter on this story: Robert Brand in Cape Town at rbrand9@bloomberg.net

To contact the editors responsible for this story: Vernon Wessels at vwessels@bloomberg.net

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