Inflation and Interest Rates

Wednesday, March 17,2021 / 12:20PM / by Coronation Research / Header ImageCredit: Adobe

Inflationcontinues to rise, with February inflation reported at 17.33% year-on-yearafter 16.47% y/y in January, and food inflation at 21.79% y/y. Policy makersbelieve that structural issues are the core problem, but we sense that theyinclude market interest rates in the mix when it comes to considering all thedrivers of inflation. This could mean that the current upward trend in marketinterest rates will be tolerated - to an extent. We are looking for 10.00% perannum 1-year T-bill rates by mid-year.

Lastweek the exchange rate in the Investors and Exporters Window (I&E Window)appreciated by 0.24% to N410.00/US$1. In the parallel, or street market theNaira weakened by 1.04% to close last week at N485.00/US$1. There are argumentsthat the current level of Central Bank of Nigeria (CBN) foreign exchangereserves, at a gross US$34.6bn, is no cause for alarm. The CBN is likely tobuild up buffers through inflows of oil receipts, now that Brent crude tradesover US$65.00/bbl again. And the Federal Government of Nigeria (FGN) may wellreturn to the Eurobond market, now that domestic borrowing costs are againhigher than external borrowing costs (at least in terms of coupon rates). Webelieve that the CBN will be able to maintain its FX reserve position at closeto the current level, though we doubt that it will be able to combine this goalwith supplying US dollars to the FX markets in the same volumes which we sawprior to March 2020. Therefore, we think that there will be sustained pressureon the Naira in the foreign exchange markets. The CBN is also trying to harnessforeign remittance flows from the Nigerian diaspora, and we note that the Nairafor Dollar scheme has only just commenced. It will likely be several monthsbefore we learn the results of this initiative.

Bonds & T-bills

Lastweek, the secondary market yield for an FGN Naira bond with 10 years tomaturity declined by 6bps to 10.34% while the 7-year bond remained unchanged at10.10% and the 3-year bond yield decreased by 54bps to 7.38%. The annualizedyield on a 349-day T-bill increased by 216bps to 4.16% in the secondary marketwhile the yield on a 354-day OMO bill fell by 95bps to 8.77%. investors seekingyield focused on the CBN's Primary Market Auction that were held on Wednesdaywith a 1-year stop-rate of 6.50% (see page 2). This week, we expect a pick-upin activity in the secondary market as T-bill and OMO maturities hit the systemand money starts to look for a home again. It is possible that investors mayreact to recently-improved T-bill yields.

Oil

Theprice of Brent crude fell by 0.20% last week, closing at US$69.22/bbl, a 33.63%increase year to-date. The average price to year-to-date is US$60.42/bbl,39.81% higher than the average of US$43.22/bbl in 2020. There were many factorsat work last week, one of them being the news that Iran has increased itsexports of crude and is allowing discounts of between US$3.00/bbl andUS$5.00/bbl for willing customers. Reuters reported that that Saudi Arabia'svoluntary output cut was 600,000 barrels per day month-on-month, rather thanthe 1.0mbpd earlier indicated. At the same time, the Organization of thePetroleum Exporting Countries (OPEC) downgraded its global demand forecast forthe next two quarters with expected second quarter demand down by 690,000bpd.The fact that oil prices have not weakened much, despite these three negativenews items, is likely significant. We think that oil prices are likely to holdup at close to these levels for several weeks. However, if high prices encouragefurther output from the US shale industry, then we would expect price gains tobe capped over the coming months.

Equities

TheNigerian Stock Exchange All-Share Index (NSE-ASI) fell by 1.74% last week witha loss of 4.03% year-to-date. Oando (+11.32%), Flour Mills of Nigeria(+10.00%), and Ardova Oil (+10.00%) closed positive last week, while ZenithBank (-15.61%), UBA (-10.06%) and MTN Nigeria (-7.06%) closed negative. TheEquities market closed bearish last week with some sell-offs. We saw an appreciationin the Insurance sector (with the insurance index gaining 2.84%, the highestperforming sub-index in the week). Our view is that overall investor sentimentcontinues to be weak amid the improvements in bond yields. There is no ModelEquity Portfolio page this week, but we will resume next week, in the meantimeintending to further our sales of bank and industrial stocks to take thenotional cash position from 25.0% to close to 30.0% of the portfolio

Inflationand Interest Rates

Where are interest rates headed? The National Bureau of Statistics(NBS) report for February puts inflation at 17.33% y/y, higher than the printfor January at 16.47% y/y, with the critical component of food inflationrunning at 21.79% y/y. The upper end of the Central Bank of Nigeria's (CBN)target range for inflation is 9.00% y/y.

As the CBN argues, inflation is not just about interest rates:structural factors are the key determinant. Insecurity in agricultural supplylines is a critical issue. We believe the following are the main drivers ofinflation: structural factors; foreign exchange rates; interest rates; creditgrowth; commodity prices. We think that CBN policymakers include interest ratesamong the factors considered to influence inflation.

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After last year's remarkable decline in market interest rates(1-year T-bill rates fell from 5.40% in January 2020 to 0.15% in earlyDecember), rates have been rising this year. The rise in market interest ratessince the beginning of January has been steep (see the chart on the left), withan average of 309 basis points added to the yields of Federal Government ofNigeria (FGN) bonds with durations of between two and 15 years.

However, over the past month (chart on the right), the yield curvein the secondary market for T-bills and FGN bonds has not changed much, theline waving like a flexed length of rope. Market participants relate that fundsstill have plenty of liquidity but nevertheless expect rates to continue goingup. This is reflected in the results of the Primary Market Auctions (PMA) ofT-bills. Last week the stop-rate for 1-year paper was 6.50% (a yield of 6.95%per annum): two weeks before that the stop rate had been 5.50%. The PMAs areconsidered more liquid and more representative of rates than secondary-marketT-bills.

Is it desirable for market interest rates to trend higher? In termsof progress towards the rate of inflation, there is little argument. On theother hand, the CBN believes that the low interest rate regime of 2020 was importantin alleviating the effects of recession (and indeed, 2020's recession waslighter than mid-year IMF and World Bank predictions). So, allowing marketinterest rates to rise now could put a brake on the recovery (the non-oileconomy grew by 1.69% y/y in Q4 2020). For this reason, the CBN might toleraterising rates, but only so far. Our view is that T-bill rates (in the PMAs) canget to 10.00% per annum by mid-year.

In the meantime, the setting of official rates by the MonetaryPolicy Council (MPC) of the CBN will continue to tread the delicate pathbetween pro-growth policies and anti-inflationary policies. The currentMonetary Policy Rate is 11.5% and the MPC is due to conclude its second meetingof 2020 this time next week. In view of inflation, a cut in the MPR seemsunlikely. In the context of fragile growth, the MPC might retain the 11.5% MPRwhile allowing market interest rates to climb further. We only rate a smallchance of the MPC raising the MPR.