Rates 10y Dashboard: South Africa’s Rate Curve Set to Steepen

As was widely expected, the South Africa Reserve Bank (SARB) left rates on hold at its MPC meeting today in a unanimous decision. Overall, the tone was dovish as the SARB emphasized its concerns about the economic recovery on the back of recent events. The immediate reaction was for the 2y rate to rally 10 bp while the long end remained steady, resulting in the curve steepening.

In the near term, we expect the curve to steepen further on the back of several drivers:

• Growth: The GDP is expected to contract in Q3 due to:
  • Riots: Following the imprisonment of former President Jacob Zuma, the country suffered its worst riots since the end of the apartheid in 1994, leaving more than 200 people dead. Businesses were damaged and key transportation routes were disrupted in the economic hubs of Gauteng and KwaZulu-Natal provinces where Zuma’s support is strong.
  • Coronavirus: The vaccination rate in South Africa was already one of the lowest among major countries. The riots have slowed down the process even further. Less than 10% of adults have received one shot of the vaccine so far while the country is seeing a spike in cases and deaths as it is going through the third coronavirus wave.
• Fiscal slippage: The riots have brought to light the country’s endemic poverty and extreme inequality, both of which have been worsened by coronavirus lockdowns. The government is discussing plans with business and labor leaders to disburse either a temporary relief grant or a form of basic income. The upcoming local elections in October would likely add to the political pressure to do so. The fiscal deficit, which was already high, is likely to worsen and pressure the long end of the rates curve.
• Inflation: While inflation has been rising in South Africa, it is well within the target band, unlike many other emerging countries. Moreover, the headline CPI declined to 4.9% YoY in June from 5.2% in May. Five-year breakeven inflation has stopped rising and has stabilized around 5% (see the first chart below).
• Monetary policy: We expect SARB to stay on hold at least through the end of the year as growth uncertainty is high and inflation is not a concern currently. Slowing growth and inflation are likely to push rate hike expectations further out and bring short-end rates lower.
• Flows: Foreign investors have net sold ZAR 45 bn of local bonds this year based on JSE data, according to Bloomberg. Foreign holdings tend to be in long-duration bonds, implying that flows are adding to the pressure on the long end of the curve, which has done well this year and has outperformed against EM as the second chart below shows.

Data Source: Refinitiv; Note: EM = equally weighted index of rates in 19 countries

If the curve steepens as we expect, then it will make it even more extreme on a historical basis and compared with the rest of EM (see the chart below). As such, instead of position for steepening now, we would wait for the curve to steepen to enter a flattener.

We had recommended a 2s10s flattener in South Africa in March when global long-end rates were selling off in sympathy with the US. With rate hike expectations rising and the high long-end yield attracting inflows, in early June, we recommended taking profits on the trade as the curve flattened. An opportunity to reenter a flattener may arise again in the near term.

Data Source: Refinitiv; Note: EM = equally weighted index of rates in 19 countries

Best Longs / Best Shorts

• The lists of underperformers and outperformers based on our models in the attached Rates 10y Dashboard pdf stayed unchanged.
• The list of underperformers consists of Chile 10y (CLP 10y), Peru 10y (PEN 10y), and Colombia 10y (COP 10y), while the list of outperformers stayed empty.

Best Crosses

• The list of preferred relative-value trades based on our models changed to Receive PEN 10y or CLP 10y vs Pay Thailand 10y (THB 10y) or China 10y (CNY 10y).
• The 3m expected returns for these pairs are in the range of 7.5-8.0% (not annualized), assuming mean reversion.