The Week that was (December 29-31 2020)
A short week with limited trading, big news is the CBN move on the USDNGN at the end of the year, President Buhari’s assent to the 2021 budget and money supply data through the end of November.
CBN weakens the Naira: Following the stealth 2-3 percent devaluation in late November, the CBN surrendered ground again, allowing a 4 percent drop at the Investors & Exporters (IE) window to NGN410/$ on the last day of 2020. The development follows an upward repricing of the Naira Non-deliverable Forward (NDF) curve on the penultimate day of 2020 by NGN2.5-3/$ and comes despite an observed improvement in FX reserves over the last one week (+1.1% to USD35.5billion). The readiness to yield on the IE rate, despite the positive trends in the external account and a wave of borrowings (USD1billion BOI syndicated loan and USD1.5billion World Bank facility) likely signal an acknowledgment by the CBN that the prior exchange rate (NGN385-395/$) is not reflective of its own underlying assessment of the fair value for the Naira. Using its Q2 2020 statistics bulletin, the CBN REER model places the Naira fair value at NGN435/$ while the 1-yr NDF curve was reset to NGN433/$ which was consistent with market views (onshore 1-yr forwards: NGN434/$) prior to the year-end devaluation.
Figure 1: NGN (Nominal and % PPP valuation)
Thus it would appear that the stealth movement hints at a more gradual approach to Naira adjustment to smoothen the convergence vs a disorderly largely scale devaluation, something the CBN governor hinted at the November 2020 MPC press briefing. However, onshore forward markets were less enthused as the forward curve repriced 6.5% on average with the market now expecting the a 15% drop in the Naira value to NGN477.56/$ by the end of 2021 which coincidentally is around where the parallel market is. I suspect this rate will adjust stronger in the coming days. In my view, likely improvement in the external accounts over 2021 as oil prices move higher, if accompanied by monetary tightening to re-engage foreign portfolio investors (and deliver real yields) could move thing closer to NGN430-440/$ than where the parallel market rate is hovering about.
Monetary aggregates remained on the expansion path in November: The CBN updated money supply data through to November 2020, which showed continued expansion across all three main monetary aggregates: M3 (+5.7%), M2 (+29.3%) and M1 (+44%). The muted growth in M3 (defined OMO bills + M2) continues to reflect the drop in CBN OMO bill issuance (-99%) following the decision to bar non-bank investors from the instrument while the expansion in M2 and M1 reflects the rotation by non-bank investors in current and term deposits amid limited investment options. To manage the fall-out the CBN continued to resort to CRR debits with bank reserves up to NGN12.3trillion (October: NGN11.9trillion). without these debits, interest rates will likely have fallen into negative territory. Therein lies the risk associated with the newly introduced CBN Special Bills, in the event that the CBN moves to repay these maturities in March, bond markets could move into fresh bullish territory on account of the outsized banking system liquidity. That said, the odds of that happening appear slim as its very likely the CBN would rollover these instruments. The big unknown is whether the rollover would occur at higher levels than the 0.5% on issue.
Naira yield curve steepening slows as some buyers returns: Into the last week of 2020 and system liquidity remained robust with overnight/OBB rates closing the year at 0.5%/0.83%. At the NTB auction, the CBN, on behlaf of the FGN, rolled over maturing bills worth NGN74.8 billion slightly lower stop rates: 91-days (0.035% vs 0.048% previously), 182-day (0.5% unchanged) and 1-yr (1.21% vs 1.139% previously). Away from the front end, though profit taking continued with yields up by 21bps on average buyers returned at the long end. Sell-offs were focused on the front end (+26bps) and belly (+62bps) while buyers were seen on the long end (down 29bps) due to strong buying on the 2050s. Over 2020, the Naira yield curve declined on average 500bps in nominal terms despite roughly steady rise in inflation resulting in average real yields of -4.9% over the year.
Figure 3: Naira Yield Curve
Source: FMDQ, NBS
The Week Ahead (January 4-8 2021)
The new year opens to sizable liquidity with OMO maturities of NGN411billion, as well as bond coupons of NGN240billion which could underpin modest bullish undertone in debt markets during the first week. Per government borrowing plans, the Q1 2021 NTB calendar shows a largely neutral posture as issuances exactly match maturities. For the long end, market focus will shift to the release of the Q1 2021 bond calendar.
2020 Review: CBN’s tolerance for local non-bank liquidity spurred a bullish run across debt markets
CBN’s decision to bar local investors (and subtly banks) from participating in its OMO bill auctions in November 2019 proved to the singular factor that underpinned developments across debt markets in 2020. The policy unleashed a tidal wave of unplanned liquidity (NGN6.1trillion), arrived as the difference between 2020 OMO maturities (NGN13.2trillion) and 2020 OMO sales (NGN7.1trillion), into the financial system. This extra liquidity alongside bond maturities and coupon payments had to scramble for limited investment outlets. As a consequence, too much money (demand) chased too few securities (supply) leading to a strong rally in bond prices (i.e large declines in interest rates) with the S&P Nigeria bond index up 39% over 2020 (A bout of profit taking in December shaved off 10 percentage points worth of returns). In all, a good year for bond investors chasing duration but a bad year for yield investors.
However, from a more theoretical (or fundamental perspective) interest rate levels appear out of sync with valuation levels implied by macroeconomic variables. Headline inflation tracked higher, rising to 14.89% by November, on account of food prices though underlying core inflation was subdued at 11%. The negative real interest rates alongside CBN’s hard stance over the NGN peg in the IE window (despite a deterioration in the external account following the drop in oil prices) induced a collapse in foreign portfolio inflows via the IE window (down 76% y/y to USD3.8billion). In the face of the dual pressures on its key monetary policy anchors, the CBN elected to slash policy rates by 200bps at two meetings (May and September) to 11.5% with its standing deposit facility at 4.5%.
In summary, despite macroeconomic fundamentals suggesting otherwise, CBN’s tolerance of greater non-bank liquidity (while capping banking sector liquidity via CRR debits) induced a rally across debt markets.
2021 Outlook: Of Steepeners and Inversions
Looking ahead, developments point to shifting cross currents. On the supply side, the FGN plans to sell NGN2.1trillion worth of debt on the local side to finance the fiscal deficit. Alongside, NGN561billion in bond maturities which will likely be rolled over 2021 looks to be another record year for bond markets after gross sales of NGN1.9trillion in 2020. On the demand side, system maturities are front-loaded over the first three months before tailing out over the rest of the year before a relative dry spell over Q2 2021, then July maturities before things really peter out. The profile speaks to robust banking sector liquidity in Q1 2021, which should depress short term interest rates assuming no big increases in CRR debits and that a roll-over occurs for the Special Bill maturities. However, non-bank liquidity while remaining robust is under less pressure relative to 2020 and is likely to be more sensitive to bond valuations. That said, any sell-offs in response to 2021 borrowings on the long end are likely to be capped at 9-10% levels (max 11%) as these levels will spur fresh buying from the segment in a yield chase. Over the second half of 2021, the July bond maturities should help calm things down leading to a moderate bull run.
Figure 4: 2021 Maturity Profile
Source: CBN * includes CBN Special Bills ** includes promissory notes
While this suggests a down-up-down pattern in yields over 2021, a big unknown however is CBN’s response to the fluid trends across macroeconomic variables. Nigeria’s likely exit from recession in Q2 2021 removes a key pillar of support for the current accommodative posture. In defense of a more hawkish shift is elevated inflation (likely to hover between 16-17% in 2021), continuing FX skirmishes (given likely muted FPI flows) and re-emergence of desire to bolster reserves organically. My best guess is that the CBN turns less tolerant of non-bank Naira liquidity at point in H2 2021 and actively seeks to curtail it. In the interim, markets are likely to going fret over the uncertain CBN posture leading to duration apathy and yield curve steepening. Once the CBN clarifies this position in favour of tightening, an inverted Naira yield – the historical default position of the Naira curve – is likely to re-emerge. How to does one play this? The maxim applies: Blessed are the flexible, for you shall not be bent out of shape!
And a one more thing…
Yield Curves and Recessions: The Nobel Laureate, Paul Samuelson once joked that the US stock market predicted nine out of the last five recessions. That said the real genius in predicting recessions is the yield curve with the appearance of an inverted US yield curve often associated with the onset of economic recessions. In Nigeria, regular watchers of debt markets would have observed the opposite: a normal yield curve (i.e. an upword sloping one) predated the 2016 recession and coincidentally the 2020 recession 🙂
Happy New Year!
I like this write up however I do have a question. The DMO has about N3.3 trillion to service debt, will this low interest rate be beneficial to them ?
The NGN3.3trn is part of the budget and so not the number to worry about. The number to worry about is the NGN2.2trn local borrowing plan. Last year, we sold NGN1.9trillion of local debt. The prospect of higher supply in 2021 under an elevated inflationary environment suggests rates will have to move up to accommodate the DMO plan. How high? not much in my view. Worst case rates move up to 9-10% levels for bonds. Any increase above this is likely to be short-lived as there is sizable liquidity ready to buy-up bonds at those levels. Short-term interest rates likely stay depressed due to the overhang of liquidity at the front end. This is why I suspect we will see an steep curve.
For the entire yield curve to really move to 13-14% you will need CBN to directly attack system liquidity i.e. seek to deliberately remove it via increased securities issuance of CRR debits. This will push the front end up as well leading to flat or inverted curve. Is CBN ready to push rates up? time will tell.