Fixed Income Research: With Inflation, Wither Yields? - ARM
Thursday, June 21, 2012 12:38 PM / ARM Research
While we are still on the topic, in yesterday’s paper, we expressed the view that headline CPI will likely trend into a 14.5-15% peak over the next couple of months, which tests the upper limit of the CBN’s putative comfort zone. This prospect probably gets investors thinking about possible impact on domestic interest rates.
This is by no means an academic question; we believe it has far reaching implications. Indeed, outlook for both economic variables and a wide variety of asset classes in Nigeria has become closely tied to trends in short term interest rates. Bond yields headed northwards in lockstep with money market rates in Q4 2011 and have remained stuck at those stratospheric levels since; money market rates themselves were headed lower since year start, but this trend appears to have been arrested by increased borrowing and currency trends. Monetary policy makers appear fixated on the idea that elevated short term rates are the key to attracting—or at least keeping —portfolio investment and, thus, currency stability. Also the fates of a substantial number of listed corporates, financials and manufacturers alike are tied, for good or ill, either directly (through lending yields and borrowing costs) or indirectly (via lending volumes and expanded credit to distributors) to money market trends. In addition, amid substantial improvements in valuations, we believe that elevated short term rates is the single most important factor keeping domestic investors shy of equities whose fickle fortunes have been left almost entirely to foreign investors (who accounted for 81% of trading volumes on the NSE as at Q1 2012) of late.
Thus, to the extent that inflation may influence yields, its prospective direction should cause some concern, but this of course begs the question that this influence, in fact, exists. So what impact could inflation trends have on yields?
Not what it’s made out to be
We examined the trend in average annualized yields for all T-bills issued in a given month alongside the contemporaneous readings in YoY headline CPI (i.e. with one lag to reflect the actual availability of the numbers) over the preceding 10 years through January 2002. The premise is that investors in T-bills will have every opportunity to react based either on expectation or the actual reading when they arrive mid-month. It’s clear however from Figure 1 that the two series bear very little relationship. A cursory analysis puts correlation between the two trends at 7.3%; positive, but too low to be meaningful. Part of the mystery in the trend is that for much of the period (72% of the time) short term interest rates are actually below inflation (i.e. negative real returns) and sometimes significantly so (-10.7ppts at the end of 2006). Lest some inadvertent bias from preponderance of shorter term paper be introduced, we conducted the same analysis with the maximum yields available on any T-bill for any given month with much the same result (see Figure 1), nor does evaluating changes in either or both parameters fare any better. This result may seem surprising but it is consistent with the experience of many economies. It also does make the CBN’s recent pursuit of positive real interest rates a normalising strategy seem a bit forced.
Figure 1: Base Rates Vs. (Average and Max.) Monthly Yields
Source: CBN, ARM Research
However, working on the notion that inflation readings could perhaps have an impact on future yields, we included further lags in monthly inflation readings relative to yields and things get a little more interesting. Figure 2 shows correlation relative to (monthly) inflation lags. Correlation between the series increase steadily from the first to the 10th lag, and drop off steadily afterwards. Somewhat disappointingly however, the correlation readings never make it beyond the 35% mark; and one may be forgiven for dismissing any causal link between the two.
Figure 2: Lagged Correlation btw, YoY CPI and Monthly Yields
Source: NBS, CBN, ARM Research
What actually counts?
So what does drive yields? We zeroed in on another obvious choice and were not disappointed: base rates. Figure three maps the relationship between average T-bill yields and prevailing policy rates, not only does the pattern look more similar, correlation between the two series is 75% (77%with max. yields) despite the significant volatility of the former relative to the latter. Our analysis is not perfect in that it does not reflect the corridor introduced around policy rates since the adoption of the corridors around MPR in 2008. Adjusting for this, correlation drops slightly to 71% (74% for max. yields) and despite intermittent periods of T-bill yields curiously falling below base (deposit) rates, the usual positive spread between the two is much more intuitive. Bringing us full circle back to the original question: what does the likely trend in inflation portend for interest rates?
Figure 2: Policy Rates (MRR, MPR) Vs. Monthly Yields
Source: NBS, CBN, ARM Research
Well, clearly, the question is best framed in the context of what the MPC is likely to do in reaction to an uptrend in CPI. Our expectations are for CPI readings to overshoot the committees target slightly at the peak. But this doesn’t necessarily mean that it will react by tightening (in which case one can reasonably expect a yield uptrend). In fact, giving likely funding pressures the government (and the CBN) may face in the near to medium term, we believe it has some incentive to do just the opposite—and this is despite renewed currency pressures that have many thinking otherwise. Hold on to that thought for now though as we revisit it soon, but one final take-away from this review is that, for those who believe in mean reversion, the positive spread between yields and policy rates were never as high as currently obtains through the ups and downs of both readings over the period in consideration. Indeed the more natural circumstance is for both to be rather close, with deviations (negative or positive) closing fairly rapidly. Thus there is a case to make for the natural direction of yields being southwards at this point.
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