September was characterised by a weakening currency and a stubbornly high current account deficit. Although the benchmark R153 finished the month largely unchanged, the yield curve started to invert and there was some volatility during the month. The inversion is the cash curve was even more exaggerated with 12 month rates rising over a third of a percent to 9.40 levels.

CPIX inflation continued to rise but remained within the target band. PPI inflation on the other hand continued to surprise the market and is currently above 9%. This will keep the SARB vigilant for any signs of pass through inflation. The robust consumer remains a concern and the Governor has used every opportunity to warn against excessive spending and credit growth. These will be closely monitored in the months ahead to ascertain how many interest rate hikes are needed to moderate their growth.

Globally the position is more stable as we appear to be at are near the peak in interest rates in the US, while the ECB and the Bank of England remain vigilant to any signs of rising inflation. The lower oil price is bringing some relief to most bond markets.

Outlook
Looking ahead we expect the MPC to raise rates at the remaining two meetings this year. The behaviour of the local currency will determine whether they will then need to raise rates further in 2007.

The positioning of your portfolio remained cautious for the month, with cash duration shortening and limited exposure to the bond market, outperforming the benchmark.

The second quarter was a volatile one for fixed income markets with yields on 12mth NCD's kicking up 1.25% to yield 8.60% and the bond market returning a negative 3.58% for the quarter. The SARB surprised the market by raising the repo rate by 0.50% at the MPC meeting on the 8th June. Out of 16 economists polled, 15 expected rates to remain on hold. The reasoning for the hike was somewhat unclear, with the bank highlighting a significant upward revision of its international oil price assumptions as the main reason for the deterioration in its inflation outlook. However, given a nervous and volatile global backdrop, the more likely reason for the SARB to raise rates is to slow consumer spending and stabilize the current account deficit.

The global market deteriorated during the quarter as the market focused more on inflationary concerns and the prospect that the FED could continue to raise interest rates further, causing growth to slow and emerging market assets to suffer the most. This led to a flight from emerging market assets as well as other perceived risky assets. Currencies as an asset class suffered the most in the liquidity shock. The Rand was the 2nd worst performing currency, loosing just under 14% along with the Turkish Lira which lost 15% over the quarter. In June, we saw a number of central banks around the world raising interest rates, including Turkey, South Korea, Thailand, India and Hungary to counter rising global interest rates and rising risk aversion

The release of a widening current account deficit of -6.4% in the SARB's quarterly bulletin in June did not help the Rand, serving as a reminder to EM investors of the larger financing needs of SA. The Rand went into freefall towards the end of the quarter, reaching a high of 7.56 to the dollar and loosing just under 50c on the month to close at 7.16 to the dollar. We reduced exposure to bonds during the quarter, investing mainly in the shorter end of the cash curve. As such we were reasonably well positioned for the move.

After rallying strongly into the start of the year, the bond market closed the quarter at similar yields to those of December 2005 and the money market ended on a slightly weaker note. During the quarter, the benchmark R153 traded to historic lows (high in price) of 7.04% before closing higher at 7.29%. The 12mth NCD rallied from October highs to reach a low of 7.20% mid January, but closed the quarter 0.18% higher yielding 7.38%. In the process the yield curve steepened, driven by the long end of the yield curve.

The initial rally was driven by a stronger Rand, which rallied 30c to the US dollar, touching just below R6 to the US dollar mid month. This drove the market to improve inflationary expectations dramatically and the market started to price in further interest rate cuts. Seasonal coupon cash flows and the budget provided further support during February causing the bond market to touch below cash yields. In March, however the bond and money market sold-off. The first part of the sell-off was driven by emerging market jitters as expectations for further rate hikes by the FED and ECB caused investors to sell emerging market assets on expectations that interest rate differentials would decline. Towards the end of the month hawkish comments by reserve bank governor Tito Mboweni gave the market the final push. Tito reiterated that the SARB expects inflation to accelerate and that the bank is more likely to raise interest rates than reduce them. Clearly, indicating that the bias to interest rates is to the tightening side.

Having revised our inflation forecasts downwards in October last year and on expectation of a positive budget in February, we positioned the fund long the benchmark and were thus well positioned for the rally. As the market moved into expensive territory and with bonds trading below cash yields, we took the opportunity to take some profits, reducing the duration of the fund.

Going forward, we maintain our view that the SARB will keep interest rates on hold over the next few meetings and remain more bullish on inflation relative to consensus. Whilst inflation continues to be a positive driver, the continued robust consumer demand pushing up credit levels as well as a widening current account remain a concern. We believe that the curve now offers more value. However, in the shorter term we are slightly more cautious on the back of the hawkish comments, thus we will continue investing in the short end, but will look for selective opportunities in the long end of the yield curve.