Going into the 2nd quarter, the long end of the money market curve appeared attractive. However, on a risk adjusted basis we felt that the 6 month area was increasingly offering value and hence continued to migrate our exposure from the 12 to the 6 month area of the curve. This positioning benefited the fund as the 6 month NCD rate moved from a high of 6.50% to 6.34% at the end of May. Key developments that weighed on markets over the course of the quarter were the national elections, the SARB MPC's decision to leave the repo rate unchanged at its May meeting, and major ratings agencies' downgrades of SA sovereign debt. Economic data released over the quarter confirmed that growth stalled and inflation has continued to increase. The data certainly bolstered our view of a very restrained rate up-cycle.

On 22 May the SARB MPC concluded its 3rd meeting of the year, leaving the repo rate unchanged at 5.5%. Much of the focus on the MPC statement that accompanied its decision was on the SARB's growth outlook, which deteriorated markedly since the previous MPC meeting. Data released confirmed that activity stalled over the 1st quarter, with GDP contracting by an annualised rate of 0.6%. The 1st quarter slump was mainly due to contraction in mining and manufacturing, but most other sectors also posted weaker growth. Recent data releases suggest that activity may have improved over the 2nd quarter, allowing the economy to avoid a technical recession. But news about strike-related stoppages in the engineering and metals industries paint a worrying picture for the 3rd quarter. However, Governor Marcus reiterated that future actions by the MPC will be data dependant and determined by developments in the outlook for inflation.

May's inflation releases were mixed, with consumer inflation rising sharply, while producer inflation eased. Consumer inflation rose to 6.6% in May, from 6.1% in April; producer inflation eased to 8.7% in May, from 8.8% in April. The increase in consumer inflation since late-2013 has been driven mainly by increases in food prices and some general feed-through of rand weakness. We expect consumer inflation to nudge higher in June, to 6.8%, trend sideways thereafter with a peak of around 7% in December 2014, and drift back into target by the 2nd half of 2015.

The higher inflation and weaker growth numbers make the MPC's future interest rate decision very difficult. As data was released, analysts' expectations, as polled by Bloomberg, drifted towards a 50 basis point rate hike in the 3rd quarter of 2014. Currently the Forward Rate Agreement market is pricing in a 25 basis point rate hike at the July MPC meeting and a further 125 basis point hikes in the next twelve months. With renewed expectations of further hikes, we saw money market rates increase over the quarter. The 3 month NCD increased by 10 basis points to 5.83%, whilst the 12 month NCD increased by 12.5 basis points.

We think that the repo rate up-cycle that was initiated in January will continue, but that it will remain very subdued compared to recent up-cycles. A further 150 basis points from here-on through to end-2016 seems reasonable, in 25 to 50 basis point increments, but the timing of hikes will be heavily data dependent. We continue to see the MPC as reluctant hikers, given the weak economic cycle, with the recent hawkish rhetoric geared towards anchoring expectations. If the data allows, as has been the case post-January, the MPC is likely to delay hikes while talking tough. However, the risk view is that near term hikes may be driven by a weakening rand and worsening inflation expectations.

Given the market expectations, we have begun to temper our risk appetite even further by positioning the money market portfolio for any potential increase in interest rates in the 3rd third quarter of 2014. Our investments are being limited to shorter dated and floating rate instruments. By doing this we have begun reducing the weighted average duration of the portfolio.

The defining event for the first quarter, and arguably for the year ahead, was the increase in the repo rate by 50 basis points at the South African Reserve Bank's January Monetary Policy Meeting (MPC). This was an unexpected move. The consensus at the time of the meeting was that rates will remain on hold until at least the end of 2014.

The post mortem of the event implicated the rand weakness as the chief reason for the marked deterioration in the Reserve Bank's inflation outlook. Annual inflation forecasts increased by 0.6% and the trajectory showed an extended breach of the upper end of the inflation target range.

The market's reaction to this premature commencement to the hiking cycle was severe in its overreaction. Especially harsh was the market's interpretation of the extent of the now commenced hiking cycle. At the height of the post meeting stampede the market priced in a total of 350 basis points in the upcycle. As the dust settled, consensus settled too and the extent of the hiking cycle moderated, helped by post MPC comments.

For now we take the MPC at its word when it argues for a modest hiking cycle, given the weak economic cycle. We expect that the MPC will hike by a cumulative 200 basis points through to the end of 2015 taking the repo rate to 7.5%.

The long end of the money market curve appears attractive. We, however, temper our risk appetite, as we recognise the risk inherent in the market. Against an uncertain backdrop regarding the international recovery and a local hiking cycle driven by volatile high frequency data releases, we feel that the 6 month area of the curve offers us attractive yields at significantly lower risk, which ultimately is the objective of this fund.

In our Q3 2013 comment we expressed the opinion that inflation was near the top and should return to the band in the coming months. This was indeed the case with consumer inflation moderating further in November, falling to 5.3% from 5.5% in October, and a peak of 6.4% in August. The temporary breach was driven by spikes in petrol prices. The decline back to the target was also driven by declines in the petrol price.

Our view on inflation in the coming months is that it will trend sideways over the next months, albeit close to the upper band of the target range. Our view on the repo rate remains that it will be unchanged until the end of the year. The risk to our view is one of an earlier hike. The probability of our risk scenario materialising has increased from the previous quarter. The increased likelihood of our risk view materialising is informed by recognizing that the local currency is in a very tough spot. It remains vulnerable on the domestic front; the current account and potential political news in the lead up to the elections will, in our view, not be supportive of a stronger currency. From a foreign perspective, the most noteworthy headwind to the currency stems from the US Fed FOMC announcement to proceed with tapering.

As the timing of the first hike approaches, we expect increased volatility and believe that the already steep money market curve can steepen further. In particular, we are of the view that the curve beyond the 6 month point is too flat, and foresee that this is the part of the curve that can potentially steepen further.

We therefore see the attractive area of the curve to be centred on the 6 month point. We prefer fixed rate paper in the 6 month area and will postpone fixed investment into paper longer than 6 months until we get clarity on the effect of the currency on inflation and in particular inflation expectations, or until such time as the 1 year area of the money market curve has re-priced to reflect the heightened risk of earlier tightening.