Position for Choppier Waters – Shorten Up!

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Wednesday, June 06, 2018  03:10PM  / ARM Research

 

In a follow-up to our post-MPC note (Monetary Policy: When will the ‘Dove’ coo?) published last month where we analysed the basis behind MPC’s decision to leave all policy parameters unchanged at its last MPC meeting and posited that the CBN could maintain status quo through H2 2018, we delineate the impact of the above on the fixed income market and give our outlook for the rest of 2018.

 

CBN makes a U-turn in May 

The downward spiral in OMO rates (-255bps Year-to-April to 12 %) due to dissipating inflationary pressures came to halt as the CBN raised OMO rates by 15bps to 12.15% in May. Even so, it intensified its liquidity strain by net issuing ~N742 billion worth of OMO bills in May after two consecutive months of net repayments (March: N182 billion, April: N70.8 billion). To our minds, the CBN is slightly drifting from its earlier posture of curling OMO rates to align with waning inflationary pressures, to now taking a proactive stance to wade off likely liquidity threats to currency.

 

For clarity, at the last MPC meeting, the focal point of discuss was liquidity and its attendant impact on currency and price stability. This is not surprising as the bloated liquidity profile over the rest of the year—emanating from elevated maturity profile (OMO: N9.9 trillion, NTB: N2 trillion), higher FAAC inflows (~+30% YoY to N650 billion) and late passage of the 2018 budget which could spur speedy disbursement of FG’s fiscal outlay ahead of the 2019 general elections—could usher in a replay of 2016 where speculation on USDNGN drove wider spread between the interbank and parallel market rates.

 

Table: Average stop rates (OMO, NTB & BOND)                            

 

 

OMO

 NTB

 BOND

Jan-17

18.30%

16.70%

17.00%

Feb-17

18.30%

16.50%

16.60%

Mar-17

18.50%

16.50%

16.30%

Apr-17

18.80%

16.60%

16.20%

May-17

18.30%

16.50%

16.30%

Jun-17

18.30%

16.50%

16.20%

Jul-17

18.30%

16.50%

16.20%

Aug-17

18.20%

16.40%

16.80%

Sep-17

17.30%

15.90%

15.90%

Oct-17

17.20%

14.70%

15.00%

Nov-17

17.00%

14.60%

14.80%

Dec-17

13.90%

            -

13.20%

Jan-18

14.42%

13.40%

13.40%

Feb-18

14.40%

13.10%

13.84%

Mar-18

14.40%

12.77%

13.51%

Apr-18

12.85%

12.08%

12.83%

May-18

12.14%

10.54%

13.52%

Source: ARM Research

 

 

Yield curve creep higher

 

After suffering its biggest MoM plunge (-173bps MoM) this year in April, following two consecutive months of compression, tides turned in May as average yields rose 39bps MoM to 12.88%. This mirrored elevation at the both ends of the curve as average bond and treasury yields tracked higher by 21bps and 71bps to 13.17% and 12.72% respectively. At the short end, CBN’s reversal to hawkishness following its attack on naira liquidity (OMO net issuances in May: N742 billion vs net repayment in April: N70.8 billion) and hike in OMO rates to wade off likely speculation on the currency drove marked decline in average system liquidity (-33% MoM to N219 billion in May 18).

 

This came despite tamer FG borrowings at the NTB auction in May as FG net repaid N135 billion. Similarly, at the long end, average bond yields tracked higher by 21bps to 13.17%. This mirrored offshore selloffs across varying long dated instruments with the 2021s being the worst hit, rising 73bps MoM to 13.27% in May. Consequently, investors demanded a higher premium for taking on FGN bonds at the May Bond auction with stop rates inching higher by 69bps to average 13.52%.

 

Figure 1: Trend in Naira yield curve

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Source: FMDQ, ARM Research

 

For the first time since January 2014, yields on the US 10-year treasury crossed the key psychological level of 3% in April 2017, signaling that higher interest rate are on the cards in the US amidst aggressive paper supply, sticky inflation (2.5%) and FED’s guidance to a faster rate hike this year. This in part explains the flashes of foreign investors sell-offs witnessed in Nigeria fixed income market in prior weeks as investors flee to safe heaven. However, the sustainability of US yields at those levels were short-lived following massive repatriation of funds into the US treasury markets.

 

Moreover, the recent political turmoil in Italy and Spain took a toll on global financial markets, sparking demand for US treasury instruments with knock on effect marking temporal pull back in US treasury yields from highs of 3.11% to 2.86% at the close of May 2018. However, given the prospect for stronger US growth over the rest of the year, expectation of sturdy job data and FED’s guidance of further rate hikes this year, we see headroom for further uptick in US treasury yields.

 

Figure 2: Trend in US 10 Year Treasury yields

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Source: Bloomberg, ARM Research

 

Scope for higher yields…

 

In many ways, the reversal to back door hawkishness via raising OMO issuances and rates and MPC’s unwavering stance to flinch its anchor rate at its last MPC meeting despite waning inflationary pressures is an acknowledgement of CBN’s unease with the expected build up in liquidity and its attendant impact on currency. In fact, as highlighted in our post MPC note, we now rule out the possibility of a rate cut by the MPC over 2018. Besides, its recent switch in posture from passiveness to being increasingly responsive to naira liquidity is a pointer to CBN’s undying quest to defend the naira. Undoubtedly, this provides room for further stickiness of OMO rates over the near term with knock on effect driving secondary market treasury bill yields higher.

 

Moreover, given that FG is running out of the $2.5 billion earmarked to refinance maturing treasury bills over 2018, we could see higher treasury bill issuances over H2 18 which could usher in slight reversal to the downward spiral in primary market treasury bill stop rates over H2 18. Furthermore, our expectation for wider fiscal deficit (+13% to N2.2 trillion over passed budgeted deficit in 2018), could prompt increased domestic issuances by the FG over the rest of the year. For context, having borrowed ~N300 billion YTD, FG’s 50:50 split between domestic and external borrowings for funding fiscal deficit points to domestic borrowings of N800 billion over H2 2018 using our estimates.

 

Overall, a strong case for higher fixed income yields over H2 18 appear to have emerged from renewed currency concern, prospect for rising US treasury yields, elevated liquidity profile and higher FG issuances over H218. 

 

Position for Choppier Waters – Shorten Up!

 

Pertinently, recent events in the fixed income market suggests that secondary market yields might have tested their 2018 lows already in April (average fixed income yields in April: 12%) and are on track for an uptrend over the rest of the year. In that sense, we see merits in positioning for high yielding OMO bills, treasury bills and commercial paper to capture high yields at the short end of the curve while avoiding the current unattractive yields at the long end.  Furthermore, we also advise running up the credit curve and cherry picking among fundamentally sound high yielding corporate bonds in a bid to lock-in high rates.

 

However, towards the end of the year when the impact of CBN’s monetary tightening, higher fiscal borrowings and offshore selloffs has pushed yields at the long end to attractive levels, investors should adopt a staggered approach to building duration with emphasis on mid-tenured bonds on the downward slope of the naira curve in a bid to ‘run-up the curve’ as hawkish influences kick into gear.

 

Overall, our strategy calls for investors to position for short dated instrument (OMOs, T-bills, and CPs) while keeping tab on attractive corporate bond issuances.
 

 

For further details, contact   Damilola Olupona  damilola.olupona@arm.com.ng 

 

 


 Proshare Nigeria Pvt. Ltd.


Proshare Nigeria Pvt. Ltd.


Proshare Nigeria Pvt. Ltd.

 

 

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