DMO switches to miserly mode at the auction, strain on banking liquidity drives front-end pressures, CBN remained dovish over May from money supply data and weak sentiment across Nigerian Eurobonds
The Week that was (June 20-24)
DMO ‘undersells’ at the monthly bond auction: At the monthly bond auction where the DMO had NGN225billion on offer, demand was fairly strong with bid-cover ratio at 2.45x (May: 2.56x). However, the DMO tapped only NGN226billion at slightly higher average yields (11.92% vs 11.82% in May). In terms of positioning, the DMO was slightly below the market bid (11.99%) consistent with a desire to contain yield upside. Looking through the data over H1 2022, gross bond sales totaled NGN1.84trillion, adjusted for maturities net borrowings via bonds is at NGN1.23trillion. Taken alongside the information that the DMO has net sold NTB papers to the tune of NGN794billion, this would suggest at that the halfway mark of 2022, total FGN borrowings for the 2022 budget is at NGN2.02trillion relative to the revised target of NGN3.6trillion (including the nearly NGN1trillion addition to the original NGN2.57trillion for domestic borrowings). This would suggest much softer monthly bond issuances going forward relative to the H1 run rate.
Mixed trends bullish for bonds, bearish for bills: Following the bond auction, bond yields traded initially bullish as investors covered for lost bids which saw declines across the curve: front (-4bps), mid (-1bp), and long (-11bps) segments. However, by Friday, markets had turned bearish following some illiquidity issues within the banking system as some of these agents sought to generate liquidity via sales. However, with FAAC credits this week, things have cooled on bonds though short-term rates remain bearish.
Figure 1: Naira Yield Curve
But bond auction settlement strains system liquidity, inducing bearish sentiments in front-end yields: Money markets were tight over the week with interbank rates hugging the 14% ceiling ‘imposed’ by the CBN via the standing lending facility rate (SLF). Accordingly, bank placement rates for large institutions tracked higher, moving closer to 9-10% from 8% levels in the prior week. The liquidity squeeze was evident in bank borrowing at the CBN’s discount window with an average daily number of NGN117billion (up from NGN55billion the prior week. Though the bond auction appears have taken the universal blame for the funding squeeze, my suspicion is that banks positioning ahead of half-year is driving a desire to hoard liquidity.
Nigerian Eurobonds continue to trade weaker, market pricing limited gains to fiscal and external accounts from high oil price environment: In line with the trend in the wider EM/frontier universe, where Eurobond yields have reacted negatively to the revised US Federal Reserve guidance of a year end target of 3.5% for its key policy rate. YTD, Nigerian Eurobonds are up 500basis points on average with Z-spreads (which capture an adjusted differential to risk free US treasuries of similar tenor) hovering at around +1000bps. The Z-spread is like Egypt and significantly less than Ghana (whose Eurobond yields are anchored on the 20% handle) but slightly worse than fellow oil exporters Angola (800bps), Gabon and Congo. This would suggest limited confidence by investors about Nigeria benefitting from a high oil price environment as FX reserves have declined thus far in 2022. Importantly the emerging discount between Naira and USD bonds of similar maturities (vs the norm of a premium) implies that there is limited incentive for the FGN to tap Eurobonds to finance the 2022 budget. While this suggests a likely swap between domestic and offshore borrowings at some point, the Finance ministry mooted talk of using its SDR monies from the historic IMF allocation in August 2021 to part-finance the offshore leg. This is possible and I suspect will be used.
Figure 2: Nigeria Eurobond curve
Money supply data showed that monetary policy remained largely accommodative in May 2022: CBN money supply data for May 2022 showed growth across key monetary aggregates with M3 up 25.9% (annualized) driven by continued expansion in net domestic assets (NDA) which rose on an annualized basis by 44%. Consistent with YTD decline in external reserves, net foreign assets (NFA) contracted 46% at an annualized pace. NDA growth reflects continued credit growth across private sector (+20.5% to NGN38trillion) and government (+89% to NGN18.3trillion) with the latter likely reflecting large deficit financing from the CBN. Cumulative CRR debits declined 2% to NGN11.2trillion over the month which is consistent with accommodative monetary policy though the CBN hiked rates at the end of the month. Overall, the broadest measure of money supply is running at 26% which would be consistent with expansionary monetary policy. It will be interesting to see this evolution over the rest of 2022.
Figure 3: Annual Growth in Monetary Aggregates
Naira remains under pressure, external reserves track higher: Despite improvements in FX reserves (up 0.9% w/w to USD39.1billion), Naira fortunes in the actual market continued to deteriorate as the exchange rate fell to NGN615/$. As for the official window, while rates are now anchored at NGN420-421/$, growing concern over the mounting FX backlog for offshore investors that were supposedly cleared within CBN intervention windows. The CBN usually sells dollars to offshore investors anywhere between NGN440-460/$ via a combination of spot and forward sales.
From a fundamental perspective, looking at updated REER data from Bruegel, the Naira at the official window (NGN421/$) is 16% above the level implied by the 10-year REER average (NGN500/$) – a proxy for the long-run PPP implied rate. This means in simple terms that the Naira is trading at a level above its long run PPP implied level which is consistent with over-valuation relative to fundamentals. In today’s currency terms, the Naira at its strongest REER number on record would correspond to an exchange rate of NGN229/$ while at the weakest would relate to NGN969/$. Taking the time path of a simple projection of monthly inflation over the rest of 2022, the fundamental REER implied level would translate to NGN551/$. What does this mean? Will Naira converge to NGN551/$? Not so as the REER level suggests where a currency should trade ideally given inflation differentials a nation’s across trading partners but in reality a confluence of factors could prevent this outcome. However, they provide a sort of north-star in terms of thinking about exchange rate valuation.
Does this suggest that the parallel market rate (NGN615/$) is cheap and limited downside from here? Not quite as the parallel market rate reflects a large illiquidity premium occasioned by CBN’s decision to proscribe dollar sales to BDC operators. Any restoration of USD supply to normalcy will drive a correction but assuming this status quo remains, the rate can head to anywhere, NGN650, NGN700 or higher.
Figure 4: Naira REER levels
Corporate bond watch: Dangote Industries Limited the holding company of the Dangote Group will look to close out on its NGN150billion bond issue with room to upsize to NGN300billion on Thursday. The issue is being hawked for 12.5-12.75% for the 7yr offer and 13-13.5% for the 10-year offer.
The week Ahead (June 27-July 1)
Into the last week of the month and market focus is likely to shift to what the Q3 borrowing calendar could look like as well as the trajectory of monetary policy.
Bond market outlook hinges on CBN either normalizing or remaining orthodox: Looking ahead, a cursory review of the outlook for key macroeconomic variables provides strong justification for higher interest rates. Firstly inflation now looks likely to blow past 20% by September 2022 driven by a mix of higher diesel and food prices. Despite stronger oil prices, Nigeria’s retention of a large subsidy tab to ensure cheap petrol prices will constrain USD reserve accumulation which will see the CBN continue with its dollar rationing posture. Fiscal imbalances, a fall-out of large subsidies, will continue to drive higher government borrowings either via the CBN or possible introduction of a supplementary budget. Given the short time left for the Muhammadu Buhari government, there is likely to be limited impetus to change much as Nigeria heads deeper into the election season. This leaves monetary policy as the main adjustment lever but will the CBN come clean and normalise? It looks to me that having delved into the esoteric world of unorthodox alchemy the apex bank is trapped in its own ‘genjetsu (illusion). For yields to rise, the CBN needs to invert the Naira yield curve by offering an instrument at real yield level which will drive a bearish re-alignment. Until that happens, the gap between bank placement rates and long-dated bond yields will continue to induce a ‘reach-for-yield’ approach to investment.
I leave you with this quote by the famed Italian sculptor and painter Michealangelo: Genius is eternal patience.