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South Africa Fixed Income Market Summary

Core Content

This report analyzes the current state of South Africa's fixed income market, focusing on credit ratings, trade recommendations, inflation dynamics, and market flows. It highlights the potential for a downgrade by Moody's, the impact of recent credit rating decisions, and the outlook for the fixed income market.

Credit Ratings

• Moody's has placed South Africa's local debt on review for a downgrade but has not yet downgraded it, maintaining the rating at Baa3, which is one notch above non-investment grade.
• S&P and Fitch have already downgraded South Africa's local debt to non-investment grade.
• A downgrade to non-investment grade by Moody's would trigger an exclusion in the WGBI (World Government Bond Index), but the decision has been postponed.
• The downgrade is not off the table, and the February budget is expected to be the key event for the final decision.

Trade Recommendations

• Short-end IRS receivers are recommended, with a focus on the 2Y2Y IRS. The current rate is 8.18%, with a target of 7.50% and a stop at 8.75%.
• Steepeners in the IRS market are also recommended, particularly the 2Y2Y vs 10Y IRS trade. The current spread is 45bp, with a target of 75bp and a stop at 10bp.
• Local bonds are viewed with caution in the medium term due to the potential for a Moody's downgrade, but there may be a short-term rally due to high term-premium, favourable inflation dynamics, and a more favourable external backdrop.
• Bonds in the 10-15Y range are favoured due to historically high term-premium. The best bonds are R186 and R2035.
• The target for 10Y bonds by year-end is 9.25%, currently at 9.35%.

Inflation Dynamics

• Inflation is expected to fall further due to weak domestic growth, favourable base effects, and subdued wage growth.
• Headline inflation is currently at 4.8%, and the market is pricing a more aggressive hiking cycle than what is expected by DB Economics and the SARB.
• The 1Y1Y IRS is currently priced at 7.67%, which would imply headline inflation of 6.1% over the next few months, not aligned with current forecasts.
• Short-end rates are too high for upcoming inflation dynamics, suggesting carry/roll opportunities.

Market Flows

• Foreign holdings in South Africa's local bonds remain at record high levels.
• Inflows into the local bond market have continued since the start of the year, stabilizing after the weak budget.
• The local bond market has seen high outflows following the weak budget, but these have since stabilized.

Key Information

• Local debt accounts for more than 60% of South Africa's government debt outstanding.
• The ANC conference (17-20 December) is the next major event that could influence the market, particularly the presidential candidate election and the "Top 6" announcement.
• The possibility of a Moody's downgrade remains, and it is likely to be unavoidable if the government fails to deliver significant fiscal reforms in the February budget.
• Credit agencies are closely monitoring the outcome of the ANC conference to assess the potential for reforms and fiscal adjustments.

Summary of Key Variables

Variable	Current	Forecast
Moody's Rating	Baa3	Potential downgrade
S&P Rating	BB+	Non-investment grade
Fitch Rating	BB+	Non-investment grade
10Y Bond Yield	9.35%	Target: 9.25% by year-end
2Y2Y IRS	8.18%	Target: 7.50%
1Y1Y IRS	7.67%	Implies 6.1% inflation
Market Pricing for Hikes	50bp by end-18	75bp by end-19
Term Premium	High	Suggests potential for near-term rallies
Foreign Holdings	Record high	Continued inflows expected

Conclusion

The South Africa fixed income market is in a volatile environment, with Moody's potentially downgrading the country's debt. Despite this, short-term rallies are expected due to high term-premium, favourable inflation dynamics, and a more favourable external backdrop. Short-end IRS receivers and steepeners are recommended for their attractive risk-reward. The ANC conference and February budget are key events that will influence the market in the coming weeks.