July's 50 basis point interest rate cut came as a surprise to us. The Monetary Policy Committee (MPC) decided to take action in the context of weak domestic demand. At the September MPC meeting the committee left rates unchanged, despite its concerns about the various imbalances in the economy. We share these concerns. The current account deficit widened to 6.4% of GDP in the second quarter, approaching the record levels of late 2007. The current account could deteriorate further in the short term as productivity levels and production in the mining sector fall because of the labour unrest. Falling productivity and above-inflation wage increases are likely to have long-term consequences for South African mining production and our trade balance. South Africa relies on foreign flows into our bond market to fund the current account deficit. The political risks, together with the labour unrest and inflationary consequences of this unrest, could cause some foreign investors to lose faith and the rate of inflows to slow. The result would be a weaker rand and higher inflation. We think the likelihood of a stable rate policy or higher interest rates exceeds the probability of rate cuts in the medium term. This leads us to favour floating rate assets and shorter dated fixed rate notes for the Fund; therefore the low duration.

The interest rate stability of the past 18 months continued in the quarter, however the market is now discounting an interest rate cut. Factors that have led investors to this conclusion include the inflation rate declining to 5.7%, a relatively weak domestic economy and the general panic about global growth. We still believe an interest rate cut is unlikely, as despite the inflation rate slowing, it is still above the repo rate of 5.5%. The growth in private sector credit extension, while below the 20% plus levels achieved in the boom times, is a fairly healthy 8.3%. The falling oil price could well lead to further declines in the inflation rate, but underlying core inflation is still above the target range on our calculations. Recent rand weakness could result in upward inflationary pressure over the next six months. The rand remains a concern for us, especially considering that the current account deficit is 4.9% of GDP at a time when the terms of trade are very much in South Africa's favour. This is a further argument for higher interest rates, as high rates are needed to attract sufficient capital flows. Our view that the market is pricing in too high a probability of a rate cut leads us to favour floating rate assets and shorter dated fixed rate notes for the Fund.

South African short-term interest rates have been stable since November 2010, a full 16 months and a new record. The reason for this stability is the relatively weak South African economy, lack of private sector credit growth and an inflation rate that has not strayed too far outside the Reserve Bank's target range.

The Monetary Policy Committee is unlikely to cut rates in response to the continued economic weakness, with inflation at 6.1%, above the 3-6% target. A further argument against a rate cut is that private sector credit extension has begun to pick up, rising 7% year on year after a period in 2011 when private credit was actually shrinking. Inflation will have to decline substantially from here to justify a cut considering the current negative real rates. We believe a sustained fall in the inflation rate is unlikely given the structural issues in the economy, including an inflexible labour market and above-inflation increases in administered prices.

A sharp decline in the oil price and international food prices could bring inflation down, but unfortunately this will very likely be accompanied by a weaker rand. The reason is that it is unlikely that only certain commodities will fall in price while others remain firm. As a commodity exporter South Africa will feel the downdraft of weaker commodity prices.

We have a cautious outlook on inflation but do not expect the Monetary Policy Committee to increase rates in the next few months. This leads us to favour the four to six-month area of the yield curve, where there is a small interest rate pick up for relatively little duration risk.

Despite market expectations for interest rate stability, interest rates are usually stable for only short periods of time. 2011 was unusual in this regard, in that the repo rate was unchanged at 5.5% for the full year. Rates have been stable for similar periods only twice before over the past11 years. However, term interest rates moved through the year as investor expectations changed, for example the 12-month NCD rate fell to 5.75% atone stage as investors discounted rate cuts because of the weak economy and stable rand. These cuts did not materialise as the rand weakened during the second half of the year, putting pressure on the inflation rate and offsetting the case for rate cuts, causing the 12-month rate to rise to the current 6.10%.

The market is discounting more of the same for rates in 2012, i.e. no changes. This is an unlikely outcome. The question is, in which direction will rates surprise the market and when? Regular readers of our factsheets will know we have concerns about the structure of the South African labour market and the rising administered prices. These factors put upward pressure on the inflation rate. Offsetting this are currently high commodity prices, which could fall, for example oil at US$110/barrel; the possibility of rand stability after the recent 20% decline against the dollar and the dire economic situation in Europe rubbing off on the Reserve Bank's Monetary Policy Committee. Consensus expectations are for the inflation rate to increase further in the short term before stabilising and falling back below6% in the second half of the year.

We agree that inflation will continue to rise, but are sceptical about whether it will fall below 6% as soon as expected. This must be put in the context of a repo rate of 5.5%, below the latest inflation reading of 6.1%. With the repo rate already below the inflation rate, an unusual situation in an inflation targeting regime, we believe the interest rate surprise will more likely come in the form of a rate hike rather than a cut, and have positioned the Fund accordingly.