Market Highlights
Money market yields continued to sell-off into the third quarter, with the middle of the curve underperforming the wings. Since June, 6mth NCD's have kicked up 0.95% vs 2yr NCD's which have sold-off 0.20%, causing the yield curve to invert. With R153's now yielding 8.63%, the bond curve is trading well through cash.

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.

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. We remain cautious on money market yields going forward, preferring the shorter end of the yield curve.

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 duration of the fund during the quarter, investing mainly in the shorter end of the yield curve. As such we were reasonably well positioned for the move.

Outlook

On the back of the move that we saw in the currency, we revised our inflation and interest rate forecasts. We now see inflation temporary breaching the 3-6% target band and are looking for the SARB to raise interest rates by a further 1 % by the end of the year. The derivative market has already priced in 1.5% in hikes by the end of the year and a further 0.50% by June 07. Whilst global volatility remains we remain cautious on money market yields going forward, preferring the shorter end of the yield curve.

After a rallying strongly into the first month of the year, the money market ended the quarter on a weaker note, with the 12mth NCD rallying from October highs to reach a low of 7.20% mid January, but closing the quarter higher at 7.38%. In the process, the yield curve steepened, driven mainly 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, but in March the money market sold-off ending the quarter 0.20% higher from January lows.

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. However, most of the move occurred towards the end of the month after hawkish comments by reserve bank governor Tito Mboweni. 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.

Going forward, we maintain our view that the SARB will keep interest rate on hold over the next few meetings and remain more bullish on inflation relative to consensus. We believe that the curve now offers more value. However, in the shorter term, we remain slightly more cautious on the back of the hawkish comments. We remain investing in the short end, but will look for selective opportunities in the long end of the yield curve.