Bond market sentiment deteriorated slightly during the third quarter as a result of higher oil prices, with both the US Federal Reserve and SA Reserve Bank coming out with more hawkish statements about inflation towards the end of the quarter.

In SA, inflation is on a rising trend but is still manageable, surprising on the downside during September. US Treasury bonds, however, responded adversely to a number of hawkish statements made by Fed governors in the wake of Hurricane Katrina, indicating that they are more concerned about inflation than growth after the disaster.

These negatives were counterbalanced by a stable to stronger rand during the period and more positive news on the local fiscal front. Revenue is much higher than budgeted halfway through the fiscal year and the Treasury department has indicated it intends to reduce next year's funding requirements rather than this year's.

But the bigger picture story internationally is concerning and investors cannot ignore what is happening there because the SA bond market is largely going to be influenced by the tides of international capital flows.

Several imbalances have built up in the US economy, including a housing bubble, debt bubble, the bond conundrum and the fiscal and trade deficits. It is difficult to tell when these might unwind but when they do, SA bonds will be affected.

Local bonds are currently at fair value, pricing in both the positive and negative aspects internationally and locally. In SA, we've seen a structural move in yields going lower. That is coming to an end and the pace at which yields decline further is likely to be much slower than in the past.

Given these macro-economic trends, we became more bearish during the quarter and positioned the fund at a shorter duration than the benchmark. This is a short term, and not long term, strategy in response to the oil price and upward trend in US Treasuries and we are on the lookout for buying opportunities in the current environment.

Over the last quarter, we have seen much volatility in global bond yields. At the end of the day, in spite of this volatility however, there has clearly been a lack of a general trend, either upwards or downwards. Typically, market action like this would tend to indicate either that the market has reached an equilibrium, or (as we believe) it is more a case of uncertainty prevailing.

It is plainly apparent that economic equilibrium has not been attained when market analysts around the world continue to point out serious imbalances within various geographic and economic markets. An oil price that spirals ever higher and fears of housing bubbles developing around the world are examples of telltale signs of such imbalances.

At this point it is difficult to say which scenario - either an expanding or a contracting in the world economy - will play out over the next 12 to 18 months and, for this reason, bond yields reflect that uncertainty. There are certainly risks to the upside in yields, make no mistake. However, equally likely is a scenario that will see a flight to safety, causing bond yields to collapse downwards.

The past quarter was a period during which disinflationary fears were paramount and global bond yields rallied, with US 10-year yields dropping slightly below 4% again. In a bigger picture view, though, these yields remain within the established 4% to 4.5% range that we have seen for practically the entire period since mid- 2003. A shock of some sorts is required to shake yields out of that range and, for that reason, we still favour portfolio structures that take into account uncertainty about future events and reflect a balanced view of these risks.

The most significant development during the past quarter has been a turnaround in sentiment in global bond markets, mainly as a result of a statement by the Fed regarding inflationary risks in the USA. This led to US bond yields moving higher, as the market wondered whether this would mean a more aggressive monetary policy approach than the current "measured" pace of rate hikes. Some concerns about the lack of risk aversion and the tightness of credit spreads on a global basis have also served as a warning that a credit event would result in a serious repricing of risks on a global basis. This would have a major impact on the pricing of emerging market debt and SA would not be able to escape this trend.
In SA, we have seen that inflation has reached a new low point just above 3%, but it would appear that the market is preferring to focus on the trend going forward. Even though the outlook is benign, with inflation expected to peak around 5% by year-end, the trend is up and therefore the market will struggle to maintain the strong downward trend we saw during the latter part of 2004 and the early part of 2005.
For now, a cautious approach with a shorter duration is favoured - especially with no change to official interest rates expected.

The last quarter of 2004 again proved positive for bonds, with yields dropping below the 8% level on the R153 bonds. As before, the key driver of this performance has mainly been local developments, with the rand proving its underlying strength. Falling inflation expectations are still working their way through the economy and the ramifications of this secular shift has only just started to become apparent within our economy. The primary long term effect of this shift is that interest rates will be in a much lower range than before, which holds consequences for asset prices, particularly within the bond, property and equity markets.
We do not expect to see the same magnitude of capital gains in 2005 as we saw during 2004, but there is very little reason to be negative about local bonds. The majority of returns from bonds will most likely come from income rather than capital gains. Inflation over the next few months will, in all likelihood, remain in the lower end of the inflation target band, but much of that inflation news is already expected and priced in. So, it will really be an adjustment of investors' perceptions that will allow bond yields to fall lower. For that to happen, the investing environment must remain benign - which is not entirely out of the question.