28 Oct Economic overview: September 2014
Expanding on the themes discussed in the August overview, let’s focus on the possible path of US interest rates and the impact on South African long bond interest rates.
The correlation between US 10 year sovereign bonds and South African 10 year bonds is very high. The domestic 10 year bond asset pricing starts with the US 10 year bond yield, adding the inflation differential between the two countries and the South African sovereign risk premium.
- We start by estimating the normalised level of the US 10 year bond over the next three years. There are various ways to estimate the level.
- Firstly we can use the US swap curve to calculate a 10 year by 3 year forward yield, i.e. the market estimation of a 10 year US swap yield in 3 years time, the market level is 3.2%. The 10 year swap is around 14 basis points above the US treasury curve so let’s settle on a yield of 3.1%.
- With the second approach we estimate the long term average yield of the US 10 year inflation linked bond (real bond), Bloomberg gives us a median of 2% since 1997 (data history is limited). To test for reasonability we calculate an implied rate of 2.15% using US 10 year nominal bonds and US core inflation, accepting 2% as reasonable. We add 1.12% expected inflation for the period using the 3 year breakeven rate (US 3 year nominal bond yield less the US 3 year inflation linked bond). This gives us 3.12% which is close to the 3.1% yield that we derived from the swap market.
- The next step is to estimate the inflation differential. We use the 5 year breakeven rates to limit noise. The US 5 year breakeven rate is 1.53% and the SA 5 year break even rate is 6.09%, resulting in an inflation deferential of 4.56%.
- The South African sovereign risk premium can be derived from a South African Dollar bond or the South African 5 year credit default swap (CDS) spreads. The risk premium is mainly driven by the default probability, as reflected by the credit rating. The SA foreign currency long term debt rating (S & P) stood at BB+ in October 1995, improved to BBB+ in August 2005 and is currently at BBB-. The rating changes followed the economic cycle up and down, however we do believe that some structural changes did occur over the past three years that could warrant the current (173 basis points or 1.73%) and expected medium term CDS spread to be wider than the long term median (151 basis points). We do not expect the rating to improve over the medium term thus expect the current spread as reasonable over the next three years.
- The result is an implied SA 10 year nominal bond yield of 9.36% (3.1% + 4.56% + 1.7%).
The two main drivers in modelling the SA 10 year nominal bond yield are the US 10 year bond yield and the risk spread. Both these drivers are highly sensitive to US monetary policy.
- The main scenario above uses market implied inflation expectations.
- Scenario 2 considers consensus economist inflation expectations.
- Scenario 3 is based on a high US growth and inflation scenario. This scenario is driven by better global growth which will support commodity prices and be positive for the Rand.
Finally we consider the current 10 by 3 year forward rate, derived from the SA swap curve, of 8.7%. The swap and SA sovereign curves are trading fairly close to each other up to the 10 year level, making this a good proxy for the sovereign forward. The average of the 3 scenarios above and the 10 by 3 forward is 8.61%, compared to the spot of 7.9% allows for a 71 basis point retracement of the South African 10 year bond.
Real GDP expectations (using IMF forecasts) are set out below: