After surprising the market with a 50 basis points (bps) rate cut in August, the South African Reserve Bank (SARB) erred on the side of caution at their September MPC meeting and made a unanimous decision to leave the repo rate unchanged at 7%. Inflation is expected to re-enter the target range in Q2 next year. The risks to the inflation outlook have become more balanced and there are fewer risks to the growth outlook.

Headline inflation continued to fall from 6.7% in June to 6.4% in August on a y-o-y basis, but remains sticky on the upside. The price of Brent Crude nudged below $67 a barrel and with the rand showing good resilience versus the US dollar, we could see some easing in the pump price of fuel. Producer Price Inflation fell by 4% y-o-y in August, versus the 3.8% drop measured in July. Private Sector Credit Extension continued to slide in August, dropping to a 40-year low of 2.3% from 3.3% in July. Money supply also continued to drop to 5.5% from 5.7%. Given the current market outlook, we are not seeing value in the longer end of the curve and will continue to remain short at these levels.

The 3-month JIBAR dropped from 7.58% to 7.02% over the quarter as the repo rate was dropped in August. At the end of September, the market is pricing in flat rates going forward with rates starting to tick up in about nine month’s time.

Global bonds have rallied after the sharp sell-off in Q2 2009, together with stronger equity markets. Inflation risks continue to remain low in the medium term and it is unlikely that there will be any pressure for Central Banks to hike rates. It is more likely that we will see a delay in rate hikes as decision makers will be reluctant to hike prematurely and curtail the potentialrecovery in growth. Local bond yields rallied across the yield curve during the quarter, but ended above the lows after the surprise cut in the repo rate at the August meeting. The benchmark R157 was 18 bps lower at 8.29%. The ALBI performance for the quarter ended September was 2.96%. The 7 -12 year area was the best performing sector for the quarter delivering 3.14%. The ALBI outperformed cash by 1.38%.

With the MPC stating that risks to the inflation outlook appear to be fairly evenly balanced, the market has taken this to read that there are unlikely to be further rates cuts. Although the current level of inflation is still above the upper target level,the MPC expects this to fall below the upper limit in Q2 2010 and remain within the target range for the rest of the forecast period ending 2011.

With the commentary that the revenue shortfall is likely to be closer to R70 billion than the R60 billion referred to by the Finance Minister, the market is eagerly awaiting further news at the medium-term budget release towards the end of October. The market has not reacted well to the recent announcement by National Treasury of an additional R200 million to be auctioned at the weekly auction. Compared to 2008, when the average monthly issuance was R2-3 billion, it is now currently in excess of R10 billion.

During the quarter, the 7 -12 year sector of the index performed best with a return of 3.14%. The rand traded stronger during the course of the quarter and ended up 2.6% against the US dollar and 2.5% stronger on a trade-weighted basis. South Africa’s country risk premium, the yield spread of South Africa’s dollar-denominated bonds over US treasuries, narrowed by 69 bps to 2.45% for the quarter ended September. Global bond yields were firmer in the US, Euro and the UK over the quarter. The US 10-year yield fell 23 bps to 3.31%, Euro area bonds fell 21 bps to 3.20%, and UK bonds fell 13 bps to 3.58%.

The current duration of the fund remains below the ALBI duration of 6.11. We see value in credit at the current levels and have been increasing our credit exposure to selected banks and State-Owned Enterprises. Although the implied inflation has improved steadily from the levels seen in December last year, with the increased supply of bonds, there are still risks to the upside.

The lower growth data has confirmed our concerns that funding pressures from government have increased and together with the funding requirement of State-Owned Enterprises, this should result in further upward pressure in bond yields. As long as this remains the case, there remains an upside risk to bond yields.

We have used the large increase in the duration of the ALBI in August to increase our short duration relative to the ALBI. Wewill look to reduce this position again due to expected weakness in bond yields. We have looked to enhance yield in the fund by adding credit exposure at the current attractive credit spreads. The remainder of the assets are in high-yielding money market assets.

The supply of RSA bonds at the weekly auctions has been increased again and together with the funding requirement from State-Owned Enterprises, this is concerning for any sustainable rally in bond yields.

The South African Reserve Bank (SARB) surprised the market and analysts alike when they kept rates on hold at the June MPC meeting, despite the market pricing in a further 70 basis points (bps) worth of rate cuts for 2009. At its previous meeting, the SARB indicated that the upside stickiness of the short-term inflation outlook could see a possible halt in the interest rate cutting cycle.

At the end of June, the market was pricing in flat rates for the next year and 30 bps worth of rate hikes in a year's time. Given the current market outlook, we are not seeing value in the longer end of the curve and will continue to remain short atthese levels. Credit exposure remains conservative in selected issues where higher yield could be locked in.

The 3-month JIBAR ticked up 40 bps from 7.18% to 7.58% as the repo rate was kept on hold in June. The FRA's have shifted up from a month ago when the market was still pricing in rate cuts. The market is currently pricing in flat rates going forward, with rates starting to tick up in about a year's time.

Global bonds sold off over the quarter on the back of growing fears of a deteriorating fiscal position and concerns of an ongoing supply of bonds as well as expectations of signs of a possible early recovery in global economies and the resultant bounce in equity markets.

Local bond yields were also weaker over the quarter with the benchmark R157 30 bps higher at 8.47%. The ALBI performance for June was -0.23% and the quarterly return was +0.29%. The 1-3 year index was the best performing sector for the quarter delivering 1.39% as longer bond yields rose ignoring the stronger currency. The ALBI underperformed cash by 1.58%.

Although the market was surprised by the MPC not easing again at the June meeting, the SARB had indicated at the previous meeting that further rate easing was unlikely because of the stubbornly high inflation. Prior to the June meeting the market was pricing in 70 bps of rate cuts. This has now changed to a flat outlook for the rest of the year. While we have seen a strong move in the currency the increased funding pressure from both government and State-Owned Enterprises has prevented any meaningful rally in bond yields.

During the month, the funding stocks bore the brunt of the weakness, with the 7-12 year sector returning -0.08% for the quarter ended June. The rand strengthened for the quarter by 19.4% to the US dollar. On a trade-weighted basis, the rand strengthened 17.5%. South Africa's country risk premium, the yield spread of South Africa's dollar-denominated bonds over US treasuries, narrowed by 137 bps to 3.14%. Global bond yields ended the quarter weaker after recovering from an aggressive sell-off in June. The US 10-year yield rose 85 bps to 3.54%, euro-area bonds rose 42 bps to 3.41%, while UK bonds rose 58 bps to 3.71%.

The current duration of the fund remains below the ALBI duration of 5.85.

We currently see value in credit at the current levels and have been increasing our credit exposure to selected banks and State-Owned Enterprises.

SA bonds are still discounting low domestic inflation across the curve. Although this has improved from the levels seen in December last year, we still don't see value at these levels.

The lower growth data has confirmed our concerns that funding pressures from government have increased and together with the funding requirement of State-Owned Enterprises, this should result in upward pressure in bond yields. Although we have seen the yields rise in the longer end of the curve, we still see increase supply pressures continuing and would expect further normalisation of the curve. As long as this remains the case, there remains an upside risk to bond yields.

The effective duration of the portfolio has been increased in June as we used the weakness in yields to reduce our short duration relative to the ALBI.

Credit spreads have been rising and we have looked to enhance yield in the fund by adding credit exposure. The remainder of the assets are in high-yielding money market assets.

Longer dated yields have come under pressure as the funding requirement has picked up with the increase in the RSA auction sizes and the resumption of the funding requirement from State-Owned Enterprises.

Amid a deteriorating domestic and global macro environment, the South African Reserve Bank (SARB) increased the frequency of meetings to monthly meetings, thus giving the SARB scope to step up the pace of monetary policy easing. The SARB met in March and cut rates by an additional 100 basis points (bps) reducing the repo rate to 9.5%. The SARB's inflation outlook is broadly unchanged from the February meeting. They expect inflation to fall towards the mid-point of the target band in Q3 2009, before exceeding 6.0% in Q1 2010, and average 5.5% thereafter.

After selling off sharply in the first two months of the year, US Bonds rallied 50 bps on the announcement that the US Treasury intended supporting the market by buying back debt. This spurred a rally in equity markets which fed through to emerging markets as the appetite for risk returned.

Local bond yields were marginally weaker after a fairly volatile month that saw the yield trade in a range of 50 bps. The benchmark R157 was up 10 bps to end the month at 8.17%. The ALBI performance for March was 0.04%, with longer dated bonds underperforming as long bond yields rose marginally faster than their medium-term counterparts. This resulted in the ALBI underperforming cash by 0.75%.

The short-term outlook for inflation remains mixed after both January and February inflation data came out higher than expected. There is also the uncertainty regarding the increase in the Eskom tariff that needs to be resolved. However, the Reserve Bank has indicated that although there could be some short term issues they are expecting the medium-term picture to improve paving the way for further interest rate relief. The market has already priced in 260 bps of rate cuts in the short end and long bonds seem to have discounted all the positive news. The expected slowdown in local growth has reflected immediately in the budget financing requirement, which has increased substantially. This has resulted in the yield curve normalising as funding pressures have increased from both government and state-owned enterprises.

During the month, the yield curve normalised with longer-dated yields rising slightly faster than the medium-term yields, while short-dated bonds were more or less unchanged. The short end performed positively, rising 0.64%, whereas the 12+ year sector was down -0.50%. The rand strengthened for the month by 4.9% to the US dollar, despite the volatility during the month. Global bond yields rallied across the board. The US 10-year yield fell 34 bps to 2.69%, Euro area bonds fell 13 bps to 2.99%, while UK bonds declined 48 bps to 3.13%.

The current duration of the fund remains well below the ALBI duration of 5.81. With the ALBI duration continuing to increase as National Treasury have been buying back short dated government bonds and issuing longer dated bonds, we have not increased our duration as bonds offer little value at the current level of yields. Although inflation is likely to come down over the year, bonds are pricing in an overly optimistic scenario. The portfolio continues to be structured with a duration shorter than the index.

We currently see value in credit at the current levels and have increased our credit exposure to selected banks and state-owned enterprises.

Relative to US bonds, SA bonds are still discounting very low domestic inflation across the curve. Although this has improved from the levels seen in December last year, we still don't see value at these levels.

With prospects of lower growth, funding pressures from government have increased and together with the funding requirement of state-owned enterprises, this should result in upward pressure in bond yields. Although we have seen the yields rise in the longer end of the curve, we still see increase supply pressures continuing and would expect further normalisation of the curve. As long as this remains the case, there is a upside risk to bond yields.

As the ALBI duration has lengthened over the month due to issuance and bond switches, the effective duration of the portfolio has been maintained. We have looked to enhance yield in the fund by adding credit exposure, taking advantage of the much wider spreads on new and existing issues.

With the shorter dated bonds already discounting 260 bps in rate cuts, we have maintained our preferred holding of high yielding money market assets. We still see value in inflation-linked bonds as a hedge against a sharp sell-off in the currency and the resultant inflationary implications.

Longer dated yields have come under pressure as the funding requirement has picked up with the increase in the RSA auction sizes and the resumption of the funding requirement from state-owned enterprises. We have used the short term volatility to marginally reduce our short position relative to the ALBI.

Amid the global financial crisis where rates have been cut aggressively across the globe, the South African Reserve Bank (SARB) cut rates by 50 basis points (bp) to 11.5% at the December Monetary Policy Committee (MPC) meeting. The SARB now expects inflation to average 6.2% in 2009 and to average 5.6% in 2010. The SARB cited an improved inflation outlook based on oil prices falling substantially, international food prices peaking and a benign local economy.

Given the current market outlook with aggressive rate cuts already priced in (the market was pricing in over 400 bp worth of interest rate cuts for 2009), we are not seeing any value in the longer end of the curve and will continue to remain short at these levels. Credit exposure remains conservative in selected issues where higher yield could be locked-in. The 3-month JIBAR fell over the month from 12.06% to 11.43% in response to the interest rate cut.

As the quantitative easing of policy rates continues, Central Banks across the world have been aggressively cutting interest rates in a coordinated attempt to avoid a deep recession. The Fed and European Central banks cut rates by 75 bp in December, while the UK eased rates by 100 bp. Local bonds rallied strongly in line with global yields with the benchmark R157 down 107 bp to end the month at 8,21%. The ALBI performance for December was 6,9%, with longer dated bonds outperforming as bond yields fell across the curve. This resulted in the ALBI outperforming cash by a massive 602 bp.

Although yields have fallen globally, credit spreads remain wide as investors' appetite for risk remains depressed. Local inflation appears to have peaked and the main drivers, food and oil prices, seem to confirm this. It will create scope for future interest rate easing, albeit at a more conservative rate to that the market has already discounted. The market is still pricing in over 400 bp of rate cuts over the next 12 months after the first cut of 50 bp in December.

The current duration of the fund remains well below the ALBI duration of 5,90. With the ALBI duration increasing as National Treasury have been buying back short-dated government bonds and issuing longer-dated bonds, we have not increased our duration as bonds offer little value at the current level of yields. Although inflation is likely to come down over the next year, bonds are pricing in an overly optimistic scenario. The portfolio continues to be structured with a duration shorter than the index.

We currently see value in credit at the current levels and have increased our credit exposure to selected banks and state owned enterprises.

Relative to US bonds, SA bonds are still discounting negative domestic inflation across the curve. Dollar and euro denominated RSA bonds continue to trade above the local rand-denominated bonds, which reflects the expensive nature of the local bond yields. While the inflation outlook for 2009 is somewhat improved due to falling oil and commodity prices, the uncertainty regarding the level of the rand and a further hike in electricity tariffs, poses a threat. With local bond yields having fallen in a very thin and illiquid market, coupled with the limited supply in December, the breakeven yield to inflationlinked bonds has fallen to 4% from 8.5% at end of June 2008. We therefore, see better value in inflation-linked bonds relative to the long vanilla bonds. As long as this remains the case, there is an upside risk to bond yields.

Although the rand has been strong to the USD in December, the USD sold off sharply against the euro. On a trade-weighted basis the rand was unchanged, having weakened to the euro but gained against a weak sterling. The rand's global status as an emerging market commodity currency makes it particularly susceptible to depreciation during periods of heightened risk aversion. A high current account deficit and the reversal of portfolio flows remain a concern. The rand gained 3,8% versus the USD for the month. Although we have depreciated by 3% to the euro, the local currency has picked up against a weak sterling, appreciating by 11% for the month.

As the ALBI duration has lengthened over the month due to issuance and bond switches, the effective duration of the portfolio has been maintained. We have also looked to enhance yield in the fund by adding credit exposure, taking advantage of the much wider spreads on new and existing issues. With the shorter dated bonds already discounting 400 bp in rate cuts, we have reduced our exposure in the 1-3 year area in favour of high yielding money market assets.

SA bond yields have continued to move lower as growth slows and inflationary expectations ease in line with other developed and emerging economies. However, there still remain risks to domestic inflation. We will maintain our short position until we see value return to the bond market.