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Nigeria Strategy Report H1 2017 (15) - Yields Set to Succumb to Gravity

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Friday, January 27, 2017 03:57 PM / ARM Research

Today’s portion of the cut-out from our core strategy document – the Nigeria Strategy Reportassesses movements in the fixed income markets over H2 2016 and posits our outlook for same over 2017.

In H2 2016 Nigeria Strategy Report, we identified a confluence of hawkish monetary policy, increased fiscal borrowings and investors demand for inflation premium as providing ammunition for yield ascent. Of the three factors, we noted that monetary policy tightening targeted at attracting FPI flows and keeping real yields positive would have the most dominant influence on yield trajectory over H2 16. Indeed, our thesis panned out over H2 16, as the CBN hiked its key policy rate 200bps to a record high of 14% and, more importantly, raised the average marginal clearing rate at its OMO auctions 617bps MoM in July to a level which remained intact over the rest of the year. Accordingly, the naira yield curve widened 446bps in H2 16, with July alone accounting for 88% of the period’s increase bringing cumulative yield expansion over 2016 to 874bps.

Having established the key influence of a hawkish CBN in stoking yield ascent in 2016, a discussion about 2017 outlook should begin with likely policy trajectory. In 2016, more than in any other year in recent memory, the surge in inflation provided a ready cover for monetary tightening in defense of the key policy anchor: the naira. In our inflation review, we highlighted that strong base effects inherent in one-off inflation drivers (electricity and fuel price hikes) set a high waterfall mark for CPI readings to surmount in 2017 to keep the current run rate. In the absence of fresh upward adjustments of greater magnitude, relative to 2016, we see subdued inflationary readings from February 2017, as removing the positive real yields justification for contractionary monetary policy. This view would sit well with a fiscal side, now shorn of the unbridled backdoor CBN deficit financing following recent rancour over breach of statutory limits. Accordingly, we believe concerns over mounting debt service burden and declining inflation should result in more forceful fiscal pressures on the apex bank to adopt an accommodative stance given its renewed attempts at economic stimulation.

Tying it all together, we see a more volatile pattern in the level and slope of the naira yield curve over 2017 with dovish monetary policy and elevated repayment cycle in Q2 16 creating a gravitational pull on yields. Farther out, the situation on the naira with our view about CBN capitulation in H2 2017 implies some form of liquidity tightening post the event, which would certainly point to further yield curve twists. Overall, we see expansion in positive real yields in inflation as reducing monetary impetus for tightening supported by a rising maturity profile as setting the stage for yields to descend the summit over H1 2017.

Yields rise to hawkish monetary policy tunes
In H2 2016 Nigeria Strategy Report, we identified a confluence of hawkish monetary policy, increased fiscal borrowings and investors demand for inflation premium as providing ammunition for yield ascent. Of the three factors, we noted that monetary policy tightening targeted at attracting FPI flows and keeping real yields positive would have the most dominant influence on yield trajectory over H2 16. Indeed, our thesis panned out over H2 16, as the CBN hiked its key policy rate 200bps to a record high of 14% and, more importantly, raised the average marginal clearing rate at its OMO auctions 617bps MoM in July to a level which remained intact over the rest of the year. Accordingly, the naira yield curve widened 446bps in H2 16, with July alone accounting for 88% of the period’s increase bringing cumulative yield expansion over 2016 to 874bps.

Figure 1: MoM change in yields

 



Examining yield curve patterns sequentially, as in H1 16, following CBN’s hawkish stance at July MPC, the short end of the curve responded more (+880bps QoQ) to monetary tightening relative to the long end (+100bps QoQ) in Q3 16. Beyond the symbolic announcement of a more aggressive stance, the apex bank signaled its discomfort about lower rates by raising clearing rate at OMO auctions and net issued N614 billion (+3x Q2 16) over the quarter in a bid to push the naira yield curve higher.

Playing a supporting role was the fiscal side, which continued its net bill issuance stance in Q3 16, pulling out N359 billion in short dated paper (more than double total H1 16 net issuance) at rates 575bps, 687bps and 573bps higher QoQ for the 91-day, 182-day and 364-day paper respectively. While the short end of the yield curve trended higher, the tamer expansion for bonds in Q3 16, reflected offsetting liquidity impact of the N581 billion 3-year FGN 2016 bond, which matured in August and underpinned net bond maturities of N120 billion in Q3 16. Lending credence to our view regarding the liquidity impact of the August maturity, bond yields no longer responded to higher inflation readings—marking a break from a pattern we observed in H1 2016, when the CBN’s announcement about keeping real yields positive spurred sell-offs shortly after CPI releases.

Figure 2: Day change in 10-year bond yields on inflation announcement

 



In contrast to the 490bps QoQ rise in Q3 16, the yield curve tightened 50bps QoQ as a 180bps QoQ contraction in NTB yields outweighed impact of a 50bps QoQ rise in bond yields. The cutback at the short end emerged despite CBN’s retention of its tight policy stance (at the MPC and OMO auctions) even as it net issued N734 billion (+19% QoQ). That said, in a reverse from Q3 16, the fiscal side pulled back from the short end of the curve by net repaying N413 billion in NTBs while it net issued N212 billion in bonds over Q4 16. Though the CBN stopped providing breakdowns on system liquidity, steep drop in money market rates to single digit in December indicates elevated liquidity which underpinned sizable CBN OMO issuance during the month.

Build-up in system liquidity likely stemmed from improved FAAC allocations post NGN depreciation, additional FGN budget support for states via cash refunds of N153 billion debt service payments and redemption of a N112 billion local contractors bond in December.

Overall, the yield curve shifted higher in 2016 as a hawkish CBN sought to raise the real returns to holding naira assets in its quest to boost FPI flows. Importantly, the concentrated CBN focus at the short end of the curve resulted in the appearance of a ‘hump’ in H2 16, as liquidity issues at the long end delayed the responsiveness of bond yields to monetary tightening till Q4 16.

Figure 3: Change in NTB yields and money market rates

 



Figure 4: Naira Yield curve

 



Markets push FG borrowing costs higher
In terms of FG borrowings, after a 58% rise in gross debt issuance in H1 16 to N646 billion from H2 15, the DMO issued N673 billion in H2 16 to finance fiscal deficit.

Though on gross basis, total bond issuance is at a record high of N1.32 trillion, adjusted for the N581 billion 2016 bond redemption, net bond issuance for 2016 is 29% lower YoY at N737 billion. For treasury bills, after net issuance of N166 billion in H1 16, aforementioned net repayments in Q4 16 resulted in cumulative net borrowings of N113 billion in 2016 relative to net repayments in 2015. Consequently, total net FG borrowings (bonds & NTBs) of N850 billion (+16% YoY) fell shy of budgeted plans of N984 billion. The lower fiscal paper supply stemmed from a softer deficit of N1.88 trillion (86% of budgeted deficit) as the FG only implemented 79% of its N6 trillion expenditure plan. Given the depth of the economic woes in 2016, the inability of the fiscal side to push through its countercyclical stimulus spending raises doubt about its credibility regarding similar pronouncements regarding the 2017 budget.

Though paper supply was less than feared, debt markets demanded a higher return for taking on FGN risk as borrowing costs rose 254bps to 15.5% in H2 16. Tracing patterns at primary auctions on a quarterly basis, whilst bid-to-cover ratios remained flat QoQ at 1.7x, marginal clearing rates in Q3 16 tracked higher (+160bps QoQ to 15.17%) forcing the DMO to rely on non-competitive bids of N126 billion (28% of total issue) to fill funding needs. In Q4 16, lower subscriptions at bond auctions, with bid-cover ratio down to 1.1x, forced further uptick in borrowing costs (+64bps to 15.82%) including a spike in December above 16%. Notably, the more expensive debt costs in December emanated after an outcry by the former CBN governor about above limit CBN monetization of FG deficits.

In our view, CBN’s tightening at the short end raised discount rate for taking long duration, forcing markets to demand a higher return at FGN auctions, with the lower and upper range of bids at bond auction climbing 240bps and 120bps from H1 16.

Unsurprisingly, the H2 16 marginal clearing rates which rose 250bps from H1 16 are highest since H1 2012. In terms of tenors, DMO maintained its issue of 10 (2026) and 20 year bonds (2036), as in H1 16, over H2 16 but switched to the new five year 2021 (vs 2020 in H1) in July.

Figure 5: Bond sales and borrowing costs

 



Oil price rally spurs bull-run across sovereign Eurobond yields
In contrast to trends along the naira curve, Nigeria’s Eurobonds declined further in H2 16 (-66bps, H1 16: -155bps) to 3.67%, 6.37% and 6.94% for the 2018, 2021 and 2023 respectively as the recovery in crude oil price boosted sentiment. The rally in dollar bond prices emanated despite negative action by credit rating agencies in 2016 as Moody’s and Fitch downgraded Nigeria one notch to B1 (April) and B+ (June) respectively while S&P moved even lower to B (September). Perhaps as evidence of the market comfort with Nigerian paper, Z-spreads to comparable US Treasuries narrowed 170bps over 2016 with 57% occurring in December, when the US Federal Reserve hiked interest rates.

That said, term spreads between the 2023 and 2021 paper and the shorter 2018 widened over 2016 (+140bps) which implies rising investor unease with long duration credit risk with Nigeria. Overall, the pattern across Eurobond yields indicates that offshore markets remain keen on Nigerian risk, more so in the light of Ghana’s $750million at 9.25% in September which was five times oversubscribed. That said, the inference from the widening term premiums suggest appetite is more for medium-term maturities vs longer dated papers. Despite the favourable market dynamics towards Nigerian dollar risk, for yet unclear reasons, the FG failed to take advantage after hinting at likely Eurobond sales in July and November.

Figure 6: Eurobond yields and Brent Crude prices

 



Away from the sovereign, after a quiet 2015 which subsisted for most of 2016, the corporate Eurobond market sprung to life in November as Access Bank with an eye on its $350 million 2017 maturity, refinanced $300 million with a new five-year issue priced a yield of 10.25%.

Liquidity influence and waning inflationary concerns meld into a dovish yield outlook
Having established the key influence of a hawkish CBN in stoking yield ascent in 2016, a discussion about 2017 outlook should begin with likely policy trajectory. In 2016, more than in any other year in recent memory, the surge in inflation provided a ready cover for monetary tightening in defense of the key policy anchor: the naira. In our inflation review, we highlighted that strong base effects inherent in one-off inflation drivers (electricity and fuel price hikes) set a high waterfall mark for CPI readings to surmount in 2017 to keep the current run rate. In the absence of fresh upward adjustments of greater magnitude, relative to 2016, we see subdued inflationary readings from February 2017, as removing the positive real yields justification for contractionary monetary policy.

However, the removal of the inflationary excuse does not automatically shift the hawkish MPC into a dovish one given the yet unclear currency outlook, as rising parallel market premiums effectively render the ‘stable NGN posture’ at the interbank as a mirage. Nonetheless, following recent improvement in oil prices and increasing talk about a potential Eurobond issue even as Nigeria looks set to receive the $1billion AFDB loan, we think the temporary boost to reserve inflows could lull the apex bank into relaxing its tightening grip, at least over H1 2017.

This view would sit well with a fiscal side, now shorn of the unbridled backdoor CBN deficit financing following recent rancour over breach of statutory limits. As we noted in our report at the time, the illumination in the press about above limit CBN monetisation of fiscal deficits should shrink use of the window. Accordinly, we believe concerns over mounting debt service burden and declining inflation should result in more forceful fiscal pressures on the apex bank to adopt an accommodative stance given its renewed attempts at economic stimulation. As we noted in our analysis of the 2017 budget, while a healthy discount would be justified in digesting FG’s bluster about an even more reflationary budget, given the disappointment in 2016 budget implementation that fed-through to lower net paper issuance, the much-improved revenue profile over 2017 suggests otherwise.

Importantly, as 2017 is the last year devoid of political considerations the Buhari administration would likely be hard pressed towards greater implementation of its fiscal plans which points to even greater gross fiscal paper supply necessitating some form of coordination with monetary policy to ease financing costs. In addition to the foregoing, monetary policy also looks set to grapple with an elevated liquidity profile for NTBs in Q1 and for bonds in Q2 16.

Tying it all together, we see a more volatile pattern in the level and slope of the naira yield curve over 2017 with dovish monetary policy and elevated repayment cycle in Q2 16 creating a gravitational pull on yields. Farther out, the situation on the naira with our view about CBN capitulation in H2 2017 implies some form of liquidity tightening post the event, which would certainly point to further yield curve twists.

Overall, we see expansion in positive real yields in inflation as reducing monetary impetus for tightening supported by a rising maturity profile as setting the stage for yields to descend the summit over H1 2017.

Figure 7: 2017 Maturity profile

 




Related News from ARM’s H1 2017 Nigeria Strategy Report
1.       Nigeria Strategy Report H1 2017 (14) - Monetary Indicators Ride Currency Waves Higher

2.      Nigeria Strategy Report H1 2017 (13) - Base Effects Set High Hurdle For Inflation

3.      Nigeria Strategy Report H1 2017 (12) - Shaky NGN Outlook as CBN Resumes Playing Ostrich

4.      Nigeria Strategy Report H1 2017 (11) - Balance of Trade Deficit: Moderation In Sight?

5.      Nigeria Strategy Report H1 2017 (10) - Feeble Steps Out Of Recession

6.      Nigeria Strategy Report H1 2017 (9) - Pension Reforms Set Sights On Infrastructure Investing

7.      Nigeria Strategy Report H1 2017 (8) - FG Fiscal Expansion: Once Bitten, But Not Shy

8.     Nigeria Strategy Report H1 2017 (7) - Energy Sector Reforms: An Unbalanced Score Card

9.      Nigeria Strategy Report H1 2017 (6) - Back and Forth on a Political Tight-Rope

10.  Nigeria Strategy Report H1 2017 (5) - Broadly Bearish Twist For Soft Commodities

11.   Nigeria Strategy Report H1 2017 (4) - Crude Oil Prices On Verge Of A Breakout?

12.  Nigeria Strategy Report H1 2017 (3)-Tightening US Monetary Policy Stokes Prospect For Portfolio Flow

13.  Nigeria Strategy Report H1 2017 (2) - Commodity Price Shocks Dim Growth Lights Across Africa

14.  Nigeria Strategy Report H1 2017 (1) - Optimism on US GDP Buoys Global Growth Prospects


Related News on Budgets
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2.      President Buhari's 2017 Budget Speech - Full Text

3.      Address by Bukola Saraki to the Joint Session of the NASS on The Presentation of the 2017 Draft Bill

4.      Remarks by Speaker Dogara at the Presentation of the 2017 Appropriation Bill

5.      Bukola Saraki's Remarks at Petroleum Industry Bill Public Hearing

6.      Nigeria Strategy Report H2 2016 - Brexit Dust Blurs Outlook for Portfolio Flows ... – Jul 30, 2016

7.      Nigeria Strategy Report Q2 2016 Outlook - Economic ... – Apr 21, 2106

8.     The Nigerian Capital Market Strategy H2 2015 – Aug 14, 2015

9.      Nigeria Strategy Report H1 2014 - ARM Research – Feb 24, 2014

10.  Nigeria Strategy Report H1, 2013 - ARM Research – Jan 28, 2013 


Related News from ARM’s H1 2016 Nigeria Strategy Report
1.     
Juggling moving parts while walking fiscal tightrope demands dexterity...  Feb 03, 2016
2.    
Sustained oil price weakness combines with policy opacity to stoke market downturn
3.    
Monetary strokes normalise yield curve - The case for a lower treasury yield curve
4.    
Monetary Policy: Rewriting the Past
5.    
Inflation rises from 8.2% in January to 9.6% in December 2015; Inflationary Pressure Likely in 2016
6.    
Another low payout from December 2015 revenues by FAAC
7.    
Renewed oil price descent swings trade balance deeper into deficit
8.    
Nigeria's GDP growth stuck in the slow lane
9.    
Petroleum sector reforms lead revamped drive for new policy direction
10. 
Fiscal Imbalance Persists on Soft Oil Price - fiscal deficit to be much higher than budget
11.  
New Government's Progress Threatened by Headwinds
12. 
Soft commodities resume bearish trend but has an inflection point been found?
13. 
FPI flows exit Emerging Market dance floor
14. 
Oil scrapes even lower down the barrel
15.  
Escalating challenges drive Africa's growth lower
16. 
Uneven global growth driving divergent policy agenda - 2016 Outlook   

 

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