• Sunday, December 10, 2023
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Still riding the carry trade


  The Nigerian yield curve has displayed mixed dynamics lately, with short-term rates drifting higher from the Feb lows – but not necessarily in a consistent trend – while bond yields retreated until early last week.

As such, the most recent inversion of the yield curve reflects, at least partially, a rally at the long end from mid-March, as illustrated for example by the decline in the yield on the Jan 22s (April 17s) from 11.6 percent (11.5 percent) on 18 March to as low as 10.7 percent (10.5 percent) on 2 April. Other on-the-run tenors generally followed a similar path, albeit at a slightly less aggressive pace.

This outperformance followed a bond sell-off between late Feb and mid-March which was the product of weaker foreign capital inflows, a related move higher in USD/NGN at the time and more bearish market sentiment. As we had expected, this subsequently created more attractive re-entry points into the duration trade, but there were certainly other technical factors that explain the above-mentioned trajectory of the long end.

First, the inclusion of 10 Nigerian bonds in the Barclays Emerging Markets Local Currency index on 1 April (with a weight of 0.97 percent) generated positive momentum for FGN instruments, even if we suspect the number of accounts tracking this index and having invested (or planning to invest) in Nigeria is limited. Second, the weight of Nigeria in JP Morgan’s Government Bond Index – Emerging Markets index was increased to 1.81 percent on 1 April from 1.44 percent previously, with two new bonds being added to the FGN sub-portfolio (Apr 15s and Oct 19s). This triggered some temporary foreign buying activity, pushing rates lower, albeit not necessarily on significant volumes. Third, local investors also contributed to the bid for FGN bonds as they took advantage of the technical downward bias in yields and the related offshore buying as well as more appealing rates post-Feb correction.

However, the price action over the past few days indicates that the offshore support may have started to dry up again, with bond rates picking up modestly (April 17s and Jan 22s at 10.7 percent and 10.9 percent on 5 April). In fact, we suspect yields reached a floor on 2 April and may well rebound further in the absence of more sizeable foreign bid and as the market positions for the 17 April bond auction (Jun 19s, Jan 22s and Jul 30s on offer). That said, any bond sell-off towards the 11.5 percent-11.7 percent mark will increasingly result in renewed investor interest for now, suggesting that FGN instruments will probably continue to trade in a relatively well defined range in the near term.

In any case, domestic market players are unlikely to be buyers of bonds at levels closer to 10 percent, mainly because they generally expect a double-digit

long run CPI path. While inflation may still remain below the 10 percent threshold until April-May (9.0 percent y/y in Jan and 9.5 percent y/y in Feb), it is only a matter of time before it accelerates (12.3 percent y/y and 10.7 percent y/y projected for Q3:13 and Q4:13), with the potential to place further upward pressure on the long end later this year. Additionally, Central Bank of Nigeria (CBN) Governor Lamido Sanusi’s decision not to seek a second term in 2014 implies that a meaningful shift in the formal monetary policy stance is improbable in the meantime and that the possibility of a cut in the Monetary Policy Rate (maintained at 12 percent on 18/19 March) has reduced considerably, especially after the NGN weakness recorded in Feb.

At the short end, rates have broadly moved higher, in line with our previously stated expectations, although this has not been a uniform and directional trend. Interestingly, this part of the curve has also become more segmented as evidenced by the differential between secondary market T-bill and special open mar


ket operation (OMO) rates. Having dropped to a low of 9.9 percent in the over-the-counter (OTC) market on 21 Feb, the 364-d T-bill yield rose to 12.0 percent on 25 March, before retrea ting to 11.1 percent on 5 April. The rest of the T-bill curve also displayed a similar trajectory over the same period. Meanwhile, primary market rates at the short end have trended higher, with the 364-d, 182-d and 91-d instruments printing at 12.05 percent on 21 March and 11.80 percent and 11.31 percent on 27 March, respectively.

The initial pick-up in yields in this portion of the curve was a reaction to slower foreign capital inflows in Q1:13 which caused a short-lived spike in USD/NGN (to a high of 159.5 on 14 March). The market realised that the risks to the T-bill curve were now shifting to the upside as the CBN was likely to intensify its OMOs and allow rates to move higher to curtail domestic liquidity and increase the incentive for foreign (and local) investors to hold NGN-denominated assets. This has somewhat been the case, and if various OMO bills printed between 10.1 percent and 11.0 percent in the first week of March, the range recorded in the last week of the month was 11.2 percent-13.3 percent (12.1 percent-12.5 percent on 4 April).

Moreover, the CBN introduced non-transferable OMO bills that cannot be re-sold in the market; this new tool helped mop up NGN437.6bn on 22 March and NGN419.0bn on 3 April, with rates as high as 14.13 percent and 14.18 percent, respectively. The non-transferable bills were obviously issued at a premium to other short-term securities because of their non-tradability (i.e., they have to be held to maturity), but one may wonder why T-bill secondary market rates have not re-priced more aggressively and even fell in late March. This suggests that there is still ample liquidity in the system despite the CBN’s sterilisation efforts which mirrors large redemptions of OMOs issued in 2012, fiscal disbursements and net foreign capital inflows. In this context, T-bill rates in the OTC market will

ably continue to hover around current levels in the near term which after all still represents a highly attractive carry trade opportunity by international standards.

Nevertheless, the concern with the current liquidity management approach is that the CBN will incrementally be forced to soak up larger pockets of liquidity in the future as current OMOs mature and some extra liquidity surplus accumulates in the system. Accordingly, the risk is that we gradually enter an upward spiral of OMO re-issuance. It is also worth noting that the CBN has strongly discouraged any foreign participation in the OMO bills lately as it feels that this would destabilise and limit the effectiveness of its

sterilisation policy, especially if more robust capital inflows eventually resume and persist afterwards.

Meanwhile, the episodic pressure on USD/NGN that became apparent in Feb and early March dissipated and the unit recouped its losses, even temporarily appreciating to 157.8 on 5 April on the back of expected Nigerian National Petroleum Corporation FX sales. The CBN has also stepped up its Wholesale Dutch Auction System FX sales (USD237.1m on 3 April) which it can afford given the build-up of foreign reserves since early 2012 (currently USD48.7bn). Looking forward, we see USD/NGN trading in a 157.5-159.5 range in the medium-term, but the long-term upward risks stem from a likely new leg of fiscal expansion ahead of the 2015 elections and the marginal oil proceeds in the

excess crude account (around USD9bn in Jan) which in itself points to a still loose federally consolidated fiscal stance. Although Nigeria as a country should post a robust fiscal surplus, the overall position is balanced at best and such a stance is only sustainable because of the relatively supportive global commodity price environment.

Should the Bonny Light price converge to USD90-95 pbl or so and remain at those levels on a multi-month basis – this is not our core scenario for 2013-14 – the current trajectory of fiscal policy would quickly become unbearable and the overall macroeconomic position would be jeopardised (not least because of likely sizeable capital outflows in this case). Besides, there would be a concomitant incentive for policymakers to devalue the currency and increase the NGN marginal

utility of every USD of oil revenue. In the meantime, there has been little progress on the Sovereign Wealth Fund reform which should have been to some extent conducive for the accumulation of more relevant oil savings.

On the external debt front, the 21s recovered in early March as the correction in the global Eurobond market eased, but moderately lost ground again over the past fortnight. The Eurobond was trading at 106.75 (a yield of 4.2 percent) on 5 April, with the spread over US Treasuries widening slightly to 278 bps (vs 302 bps for EMBI+). While the weakness experienced in Feb mirrored concerns about the outlook for monetary stimulus in the US, it seems that the emerging market Eurobond asset class has somewhat suffered from a less constructive risk environment in late March as the crisis in Cyprus escalated, suggesting that the 21s’ relative underperformance did not occur in isolation. Perhaps the irony is that the disappointing US payroll data released on 5 April will prolong the cycle of loose global monetary policy, which in turn should keep US treasury yields in check for now. Interestingly, the UST 10-y yield fell to a low of 1.69 percent last Friday from a yearly high of 2.06 percent on 11 March. Yet we still feel that the valuations of the Nigerian Eurobond are too tight amid a relatively lower oil price in 2013 and continued domestic fiscal distortions. As such, we remain underweight the 21s, but will consider investing in the new sovereign Eurobond planned for this year (or other potential USD tradable debt issued by Nigerian public and private sector entities), subject to the pricing.



Gadio is Emerging Markets Strategist at Standard Bank, London.