The reality of higher-for-longer interest rates and inflation is setting in, sending US bond yields to their highest levels since 2007, prompting economists to put pressure on the US Fed to raise its inflation target to 3% and sending US equities in a downward tailspin.

These developments signal an abrupt change in sentiment from a couple of weeks ago when the weight of opinion was embracing the prospect of a Goldilocks scenario in which growth, inflation and interest rates would be neither too cold nor too hot.

The shift can be ascribed to the ongoing resilience of the US economy and the expectation that the Fed will take longer to begin reducing interest rates.

The impact much higher bond yields are likely to have on the global and local financial markets will depend entirely on which component of the US yields drives the increase, says Prescient Investment Management Head of Fixed Interest, Reza Ismail.

“The recent increase has been driven jointly by the increase in average expected nominal short rates (this idea of policy rates remaining ‘higher for longer’), but also because real-term premia have increased on the back of better prospects for real economic activity. 

“Better real activity from the US on its own is usually positive for pro-cyclical, open, emerging economies like South Africa.”

He disaggregates the factors contributing to the 83-basis point (bp) increase in the US 10-year bond yield to around 4.3% since the end of April 2023. He first quantifies the proportion of the increase that reflects the market’s reassessment of how long policy rates would need to remain higher and puts this at 57 bps, which makes it the predominant contributor.

Next is what is called the nominal term premium, which is the increase in the compensation the market requires for taking duration risk, namely investing in longer-term bonds for which projected returns are more difficult to ascertain, and this, he says, has contributed 26 bps to the 83-bp increase in 10-year yields. 

“Finally, he notes the inflation risk premium has decreased by 20 bps because there is now greater certainty about where inflation will average over the next 10 years.

This week, central bankers will meet at Jackson Hole in the US, and the messaging coming out of that will undoubtedly shift market sentiment again.

Jerome Powell’s take on the current economic and inflationary environment will either provide confirmation of the current higher-for-longer view or portray a more dovish view.

These profound shifts in outlook highlight the impact central banks’ data-dependent stances are having on the financial markets and investor fortunes. The outcome is that investors focus even more acutely on single data points, knowing these will inform what central banks will do at upcoming meetings.

Covid economy impact ‘woefully underestimated’

The US Federal Reserve led the pack when it announced decisions would be data-dependent after it had woefully underestimated the inflationary impact of the Covid economy, subject to intense criticism for having viewed it as transitory.

Coronation Fund Managers Head of Fixed Interest, Nishan Maharaj, says data dependency does inject volatility into financial markets because the market focus is on every data release and contributes to investor uncertainty about central banks’ next move.

Thus, the intense scrutiny of short-term data has contributed to investors finding it even harder to see through the noise and spend that energy on assessing the likely longer-term outlook, which has become all the more difficult to pin down as the world economy shifts to a completely different economic regime.

There’s general agreement that the ultra-low interest rates and low inflation rates of the past few decades are a thing of the past, and that global economic fragmentation will be a hallmark of the future.

Within this context, it’s no surprise that the higher-for-longer narrative is taking hold. But what does that mean for the global and local South African economies and financial markets?

The selloff in US Treasuries at the long end of the yield curve has been a surprise – and significant by any measure.  

Homeowners stand to be the biggest losers because US mortgage rates are usually priced off the 10-year yield. Stock markets traditionally lose ground when yields are this high because companies must pay higher interest rates when borrowing, and investors can get equity-like returns from fixed-interest assets.

South Africa’s government bond yields have gone up in tandem, as is to be expected, because, as Ismail notes, the primary influence on the level of South African bonds is the trajectory of US bond yields. 

He adds that domestic yields are, and have always been, principally determined by global factors. 

Another contributing factor is the quagmire Chinese policymakers are facing, trying to address the twin current issues of deflation and default, which also have a global impact on financial markets.

Maharaj says emerging market bonds, including South Africa’s, are repricing their base rate in response to what has been a 50 bps rise in US bond yields in the past month alone. 

While SA bond yields have also reflected South Africa’s souring economic backdrop since the beginning of the year, he expects US interest rate developments to largely determine the outlook for yields for the rest of the year, barring a significant deterioration in the domestic fiscal backdrop when the MTBPS is released in October.

SA inflation

Conditions on the monetary policy front are looking more encouraging, with South African inflation returning to the target range of 4% to 6% in June, and this week’s consumer inflation number declining further to 4.7% in July from 5.4% in June – its lowest level since July 2021. 

However, the monthly increase of 0.9% was much higher than the previous 0.2% in May and June, highlighting that there are still price pressures in the system. 

Maharaj doesn’t expect the SA Reserve Bank to cut rates until it sees inflation is sustainable at around 4.5%. He says there is a risk that inflation will tick up again this year, and that would likely push out a rate cut to the second quarter of next year.

With so many moving parts and investors ready to move on a dime, today’s higher-for-longer outlook could become more optimistic after this week’s Jackson Hole conference. 

But what the past couple of years show is that while inflation may be coming down, data can just as easily disappoint and change the prevailing economic sentiment overnight. DM