In a fairly dovish statement, the Reserve Bank decided to leave the repo rate unchanged at 5.5% in the September MPC meeting. The sharp fall in the rand towards the end of Q3 2011 probably helped produce the unanimous decision, even though a rate cut was discussed. The balance of risks, downside for economic growth and upside for inflation, allowed the MPC to announce an unchanged policy rate. The portfolio was positioned for an unchanged rate decision, so the decision to keep the repo rate on hold had no material impact on the portfolio.

September was just a glimpse of how fragile the world economy is. Austerity and sovereign debt problems surfaced once again, with talk of a Greek default becoming ever more certain. Another European bailout package was proposed with the market not being as convinced, resulting in heightened risk aversion. Equities and emerging markets took the brunt of the sell-off as investors moved into the perceived safety of the US dollar. This was coupled with President Obama introducing another $400bn stimulus plan targeted at purchasing long US government bonds in order to reduce mortgage refinance rates for struggling home-owners. As a result, the US government curve has flattened substantially with the spread between the two-year and ten-year rates narrowing from 200 basis points (bps) to 167 bps. The lower for longer rates policy looks to definitely be on the table.

Local bond yields weakened across the curve as yields rose due to foreigners selling bonds during the month worth over R16bn, a complete reversal from August where they purchased R12bn. Year-to-date, foreigners are still net buyers of R34bn of bonds. During the month, the benchmark R157 was up 48 bps from 6.50% up to 6.98%, while the long-dated R209 was 61 bps higher at 8.94%. The ALBI performance for the month ended September was -2.09%. The 1-3 year area was the best performing sector for the month delivering -0.27% and the 12+ sector was the worst performer with - 3.64%.

Risk aversion has increased volatility and inflation uncertainty at the long-end, while low growth concerns limits the increase in short-end yields together with the implications for government's fiscal position and bond issuance.

The portfolio continues to be underweight in the 7-12 year and 12+ year sector as these sectors are most likely to be affected by funding pressures. The duration of the portfolio remains shorter than that of the ALBI at 4.28 and 5.84 respectively. Although we remained shorter than the ALBI duration, the yield curve steepened sharply over the quarter, which helped with our underweight position being mainly at the long end of the curve. We took advantage of the rally in bond yields in Q3 to roll our November 2011 bond options to February 2012 and lock in the fall in yields.

We continue to hold credit to take advantage of the additional pickup in yield with the credit exposure remaining basically unchanged, and while credit spreads seem to have stabilised, demand remains in the shorter area of the curve. We continue to be very selective at current levels.

Global bond yields continued to rally on concerns around the European sovereign debt issues. Markets have been volatile although some immediate concerns have been alleviated with the Greek parliament having passed additional austerity measures. Local bond yields ended the quarter firmer across the curve as yields fell on continued foreign interest. The benchmark R157 was 32 bps lower at 7.50%, while the long-dated R209 was 13.5 bps lower at 8.90%. The ALBI performance for the quarter ended June was 3.89% and outperformed cash by 2.76%. Foreigners returned as buyers of R42.3 billion in Q2 after having been sellers of R7.1 billion in Q1. Net buying for the year-to-date is R34.7 billion. During the quarter ended June 2011:

oThe 12+year sector of the index performed best with a return of 4.89% while the 1-3 year area was the worst performer with 2.17%;

oThe rand traded a range from R6.60 to R7.05 against the USD in Q2. It ended the quarter marginally down 0.12% against the US dollar and down 1.48% on a trade-weighted basis; and

oSouth Africa's country risk premium, the yield spread of South Africa's dollar-denominated bonds over US treasuries, was unchanged at 1.36% over the quarter. Global bond yields ended the quarter firmer.

The duration of the portfolio remains shorter than that of the ALBI. The underweight position in bonds is mainly at the long end on the curve where we see the main funding pressures. This is also the least attractive area of the curve with respect to the implied inflation from US bonds. Over the quarter, the portfolio underperformed relative to the ALBI by 0.34%. The credit exposure remains basically unchanged, and while credit spreads seem to have stabilised, demand remains in the shorter area of the curve. We continue to be very selective at current levels. Although bonds are showing value with implied inflation now at levels between 6.0% and 7.0%, there still remain concerns as to how the supply will be absorbed. Although foreigners have remained as buyers during the quarter, the flows have been volatile over the past year. This could mean that yields may remain cheap for longer, especially at the back end of the yield curve. On the back of the current fundamental data, it would seem unlikely that we will see a hike in interest rates soon without there being a sharp change in the inflationary outlook as well as an improvement in the demand side on the economy. However, the funding requirement needs to be maintained and these pressures should see yields higher over the longer term. The portfolio is structured to favour an upside move in bonds yields while continuing to hold the credit to take advantage of the additional pickup in yield. We have rolled over the option position to put in place some protection for any further fall in bond yields.

At the February 2011 MPC meeting, Governor Gill Marcus reiterated that the risks to the outlook for domestic inflation have increased on the upside, mainly as a result of cost push pressures. Marcus added that the MPC would not "be soft" on inflation going forward, implying that they would use monetary policy to stem a possible inflationary spurt.

Two of the factors which the South African Reserve Bank (SARB) quantified as potential upside risks to the inflation target continued to dominate the spotlight in March. The price of Brent Crude rose 4.9% for the month, but this was counterbalanced to a certain extent by the rand that strengthened by 3% versus the US dollar. Year-to-date, Oil has risen by 23.9%, and with the rand having weakened by 2% in the same period, we may see continued upward pressure on the inflation outlook going forward.

Headline inflation numbers remained flat in February at 3.7%. Producer Price Inflation (PPI) broke its five month y-o-y decline, rising from 5.5% in January to 6.7% in February. The sudden jump, after what had been a gradual drop over the last five months, pushed PPI back to levels last seen in September 2010.

Stronger economic growth forecasts and rising inflation pressures have resulted in global bond yields shifting higher. Expectations are for the ECB to hike rates at the next meeting and the FED is also not expected to continue with Quantitative Easing after the current QE2 expires in June.

Local bond yields ended the quarter mixed as shorter-dated bonds firmed on the back of a recovery in the currency, while longer bonds remained weak on supply and inflationary concerns. The benchmark R157 was 51 basis points (bps) higher at 7.82%, while the long-dated R209 was 76 bps higher at 9.04%. The ALBI performance for the quarter ended March was -1.57%. The 1-3 year area was the best performing sector for the quarter delivering 1.27% and the 12+ year was the worst performer with -3.92%. The ALBI underperformed cash by 0.26%.

The latest Inflation data for January was 3.7% which was slightly above the December print of 3.5%. The market is concerned about the longer term impact of the recent rise in food and oil prices. After a hefty increase of 43 cents in the petrol price in March, we could be in for another +50 cents in April.

The current duration of the portfolio has been adjusted so that the portfolio should benefit from rising yields, while protection has been acquired in the event that yields fall.

Credit spreads has seen a compression over the last couple of months, although there still seems to be demand. We continue to be very selective at current levels.

Although bonds are showing value with implied inflation now at levels between approximately 6.5% and 7.5%, there still remain concerns as to how the supply will be absorbed and yields could remain cheap for longer, especially at the back end of the yield curve.

Although there is no immediate pressure on inflation, we are starting to see signs of a recovery in vehicle sales, retails salesand credit extension, which suggest that we may have seen the end of the rate cutting cycle. Although we have seen some recovery in the rand, the continued strength in the oil price is likely to raise inflationary concerns down the line.

We are being very selective about adding credit exposure at the current credit spreads. With expectations that the inflation cycle could be turning up again, we have unwound the inflation-linked swap hedge that was instituted late in 2009.

Although we are seeing value in bonds, especially in the shorter area, the increased supply of RSA bonds does pose an upside risk to yields, and is be a concern for any sustainable rally in bond yields.

At the November meeting of the Monetary Policy Committee, the repo rate was cut by 50 basis points (bps) to 5.5%, the lowest level since 1974. The Governor reiterated that there was further room for stimulus, given the weakness in the supply side of the economy, but also tempered expectations of further cuts, stating that the inflation outlook remains evenly balanced and key risks remain to the lowered inflation outlook going forward. With no South African Reserve Bank Meeting in December, commentators focussed on the market components which could influence short-term inflation and the possible long-term effect it might exert on headline inflation.

Bond yields are currently fairly valued discounting around 5.5% inflation. Supply of bonds could be a concern should we see any withdrawal in the foreign participation in the market. Credit exposure continues to be managed on a very conservative basis.

International bond yields have weakened sharply over the quarter as the economic outlook in the US shows signs of improving, while sovereign debt issues continue to pose problems in the euro region. On the other side of the world Australia, India and China recently hiked rates mainly on inflation concerns. This uncertainty has translated into volatile currency and bond markets.

Local bond yields were higher at the longer end of the curve as yields trended weaker on the back of weaker global bond markets as well as foreign selling. A stronger rand supported shorter-dated bonds. The benchmark R157 was 1 bp higher at 7.31%, while the long-dated R209 was 32 bps higher at 8.28%. The ALBI performance for the quarter ended December was 0.75%. The 1-3 year area was the best performing sector for the quarter delivering 1.83% and the 12+ year area was the worst performing sector with -0.63%. The ALBI underperformed cash by 0.46%.

Demand for local bonds continues to be driven by foreign flows. Foreigners were again net sellers of R6.9 billion in December after being net sellers of R8.6 billion in November and R1.6 billion in October. Foreigners were net buyers of R36.6 billion in Q3 2010.
During the quarter, the 1-3 year sector of the index performed best with a return of 1.83%. The rand ended the quarter firmer -up 4.9% against the US dollar and 3.3% 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, widened by 2 bps to 1.51% over the quarter. Global bond yields ended the quarter weaker. The US 10-year was 72 bps weaker at 3.28%, euro area bonds yields rose 67 bps to 2.98%, and UK bonds rose 43 bps to 3.40%.

The current duration of the portfolio has been adjusted such that the portfolio should benefit from rising yields while protection has been acquired in the event that yields continue to fall. Credit spreads have continued to compress over the last couple of months on the back of increased demand and an improved outlook. We are being very selective at current levels.

Although bonds are showing value with implied inflation now at levels around 5.5% to 6.0%, there was no indication in the Medium-Term Budget that the increased revenue would be used to reduce local funding. Foreign flows have turned negative in the past three months and yields have risen as a result. Although there is no immediate pressure on inflation, we are starting to see signs of a recovery in vehicle sales, retails sales and credit extension that suggest we may be close to the end of the rate cutting cycle and the probability is more in favour of a rate hike than a rate cut in 2011.

We are being very selective about adding credit exposure at the current credit spreads. We have swapped out our inflation-linked exposure as we see the risks being that inflation prints lower over the coming months which would erode the benefits of the positive inflation carry. Although we are seeing value in bonds, the increased supply of RSA bonds does pose an upside risk to yields, and would be a concern for any sustainable rally in bond yields.