Short-end positioning amid EM debt correction

The Nigerian fixed income market has experienced increased volatility in recent days, with yields backing up substantially to multi-month highs across the curve. This was consistent with a correction in emerging market (EM) debt rates, both in the local currency bond space and the Eurobonds issued by these economies. For example, the yields on virtually all the bonds part of the GBI-EM index rose from the second half of May, while the EMBI+ spread reached 330bps on June 11 (a high since Aug. 2012).

Broadly speaking, the downturn in emerging debt and FX markets reflects concerns over the future of the FED’s massive quantitative easing programme and a possible reduction in the magnitude of US monetary stimulus. Such prospects have been openly mentioned by the FED, but still remain somewhat conditional on a sustained improvement in the US economy and labour market.

Nigerian FGN bonds tumbled over the period as the spike in risk aversion initially led foreign investors to lighten up their exposure to the long end, which was subsequently followed by some meaningful domestic selling, but also an intermittent re-pricing of the curve.

The benchmark 22s lost around 18 points to 109.1 as of June 11, the equivalent of a yield of 14.5 percent, from 11.3 percent on May 17. In fact, the market virtually shut down and bid offer spreads widened significantly.

With emerging market bond funds starting to face withdrawals, the risk is still that an increasing number of offshore investors may capitulate and exit their FGN bond positions, which would push up yields to 2012 highs. Nevertheless, Nigerian bonds continue to offer the highest yields in the GBI-EM universe and substantial real rates of return domestically given that inflation has remained in single digits YTD (9.1% y/y in April).

Clearly, the ongoing market correction will offer appealing re-entry points into bonds, but the timing of this turn is uncertain at the moment. In this context, the adequate strategy is probably to put in a defensive bid at the June 12 bond auction (April 15s, April 17s and July 30s) and, if possible, get filled at close to 15 percent in the middle of the curve.

While domestic investors have generally tracked any meaningful shift in the foreign positioning, CBN Governor Sanusi Lamido Sanusi’s comments on a possible hike in the MPR if public spending increased further also partially contributed to the upward move in bond yields. Indeed, investors anticipated until early 2013 the possibility of a moderate cut in the policy rate on the back of the improving inflation outlook. Yet these expectations have been much more neutral lately, especially as the CBN allowed market rates to pick up amid more aggressive open market operations (OMO) from late Q1:13.

Although it appears that the risks to the MPR are now possibly to the upside, our core scenario is still that the central bank will maintain the benchmark rate unchanged in the medium-term and continue to drive effective monetary policy via its OMOs. This has proved to be a relatively more effective and flexible approach to manage liquidity conditions and market rates and has helped achieve exchange rate stability. Perhaps the challenge has been the vicious cycle of sterilisation of previous OMO maturities and the extra liquidity coming from fiscal disbursements (and capital inflows until recently). Interestingly, a rising minority in the MPC voted for a cut lately (three to seven on May 20/21), which in itself implies that there is likely to be a heated debate about any potential increase in the MPR in coming months.

Meanwhile, the long end of the curve also re-priced because of the aggressive back up in short-dated yields. For example, the yield on the 364-d tenor reached 15.6 percent in the secondary market on June 11, which represents a high since August 2012. In the primary market, the 364-d T-bill printed at 14.46 percent at the June 5 auction, from 13.59 percent on May 22 and 13.21 percent on May 9. At such levels, the carry trade looks extremely attractive given the rate differential between Nigeria and advanced economies. We continue to see value in the 6-m and 12-m tenors and this position looks like a safe bet given the less certain immediate outlook for duration and as further pressure on the NGN would probably lead the yield curve to incrementally shift up.

USD/NGN has broadly continued to trade in a multi-week 157.5-159.0 range until recently, albeit closer to its upper end since late May. Yet the unit broke the 159 level on June 7 (159.75 [and even 160 intraday on June 10]) amid less significant than expected NNPC flows, weaker confidence, net portfolio outflows and further upward USD/NGN positioning.

Accordingly, it is likely that the CBN will keep intervening in the market in the near term and selling USD directly to the banks to defend its nominal monetary policy anchor (as it already did a few times over the past couple of weeks).

Because the USD/NGN exchange rate is heavily managed, the unit has not experienced the same type of depreciation against the USD as displayed by more flexible emerging market currencies (Russian ruble, Brazilian real, South African rand and Turkish lira). Nevertheless, the CBN has been forced to gradually increase the size of its WDAS FX sales which have reached or exceeded USD300 million per auction since late May. Further, NGN weakness would also increase the likelihood of a new round of aggressive OMOs and ensure higher market rates for longer as CBN Governor Sanusi will almost certainly take all necessary measures to defend exchange rate stability during the remainder of his term.

Overall, the key risks to the currency stem from a potential sizeable reversal of capital flows and/or another leg down in the oil price. The CBN has enough ammunition to address a temporary USD demand-supply mismatch, with FX reserves standing at USD48.5 billion on June 10, but those have actually flattened in recent months and most of the accumulation until early 2013 was on the back of capital inflows rather than fiscal savings. The current composition of offshore portfolio holdings is dominated by real money accounts (and less by hedge funds unlike in 2007-08), but this does not necessarily mean that real money investors will not be forced to partially pull out should they face large redemptions.

Additionally, the inability of the Nigerian authorities to rebuild fiscal savings and the continued depletion of ECA (only USD5.3bn left in May) do not bode well for the future. Such massive federally consolidated fiscal expansion can only be sustainable as long as the oil price remains high, but the latter has declined moderately in Q2:13 (USD104.9 pbl on 11 June) and remains vulnerable to a downward correction given the muted demand outlook. Although we do not foresee a sharp fall in the Bonny Light price, even a slight drop below USD100-95 pbl will be enough to trigger a sell-off in Nigerian assets and place more pressure on the NGN.

On the Eurobond front, the Nigeria 21s lost nine points to 110.5 (as of June 11) since the highs reached in April, with their yield backing up to 5.1 percent amid a widening spread over UST (316 bps) and an increase in US treasury rates.

Clearly, our recommendation to remain underweight Nigerian Eurobonds (including the GTB 16s and Access Bank 17s instruments) was appropriate. This reflected their tight valuations which had been fuelled by global liquidity and an extra layer of demand from domestic financial institutions. Despite the above mentioned correction, we continue to think that most Nigerian hard currency bonds generally do not offer value at present.

The performance of the Nigerian Stock Exchange (NSE) remained surprisingly largely positive in recent weeks, with the All-Share Index advancing 21.1 percent since early May and 42.8 percent YTD. It outperformed by far the MSCI Frontier Markets index, which gained 4.4 percent and 14.2 percent in the same timeframe.

The key question is however whether the NSE and other African frontier equity markets can continue to trend higher at a time when the MSCI Emerging Markets (-6.3% since early May) and MSCI World index (-0.4%) have either lost ground or flattened and global risk sentiment deteriorated?

Add to this rising fixed income yields in Nigeria and the upward pressure on USD/NGN, and one may start thinking that the rally in Nigerian equities (so far predominantly fuelled by international investors) is becoming overextended. Perhaps it is time to be more stock-specific and consolidate positions in names with still sound fundamentals, and not get carried away by the overall exuberance of the domestic equity market. 

 

Gadio is Emerging Markets Strategist at Standard Bank, London.