2022 Review: Bear flattening as short-term rates lead the curve higher
Following the deep bear market of 2021, when fixed income yields reversed from the lows of 2020 and bond prices slumped 35%, the year 2022 opened to bullish sentiments occasioned by a tidal wave of liquidity from the uncontested redemption of the January 2022 FGN bond. The repayment of this bond with principal of NGN605billion overwhelmed domestic money markets pushing interbank rates to low single digits 5-6% and worked to entirely offset longstanding fundamental concerns (rising inflation expectations, high projected fiscal borrowings and worsening USD liquidity) which had stalked domestic debt markets for some time. Indeed, the trend was so bullish that bond markets were up over 10% at some point in H1 2022. However, after reiterating a dovish theme at its January and March 2022 monetary policy meetings, the CBN changed course at its May meeting when it delivered the first of many rate hikes (totally 500bps over the year). To be sure, this was a complete reversion to monetary orthodoxy (from its three-year dalliance with unconventional monetary policy) as the CBN hiked the rates on its intervention loans and returned to quantitative tightening with large adhoc CRR debits which closed November 2022 at NGN12trillion. The net effect of the change in CBN posture towards a tight stance was that rates along the Naira yield curve closed 2022 up +174bps. The upswing was uneven across the curve: with the 1-2year portion seeing a 374bps increment, relative to 230bps on the belly and 174bps on the long end. This was driven by the re-pricing in 1-yr NTB yields after CBN tightening dried up banking system liquidity. Overall, the yield curve bear flattened in tandem with the call in our 2022 outlook.
Figure 1: Naira Yield Curve
From a fundamental perspective, inflation surged over the year (up 586bps to 21.5%) following shocks to energy prices (in particular diesel) with knock-on effects on food prices, alongside further currency weakness. This upswing implied no changes in real yields which closed 2022 at negative 6.6% unchanged from 2021 levels. However, the repricing in yields drove a compression in term premiums from 620 basis points at the end of 2021 to 220bps which is near trend levels and would suggest less impetus for wild swings going forward but more range bound trading trends in bond yields.
Figure 2: Nominal and Real Bond Yields
Source: Authors Calculation
In terms of demand and supply dynamics, the DMO sold a record NGN3.1trillion worth of bonds (including a NGN164billion sukuk sale) up from 2021’s record of NGN2.7trillion which is testament to the large fiscal deficit. The increased bond supply meant that the government had to pay a higher cost and indeed average stop rates at the monthly bond auctions rose to a three year high of 13.05% (2021: 12.22%). On the NTB segment, the DMO was less predictable with the debt agency electing to net issue NGN783billion in H1 2022 in response to the liquidity surfeit at single digit yields while it shriveled over H2 with net redemptions of NGN81billion as tight money market conditions and elevated bank placement rates made short-term borrowing more expensive.
In terms of CBN activity, the apex bank net repaid over NGN1trillion into money markets as it continued to shrink the size of its OMO bill position which closed the year at NGN230billion. This is a remarkable number as the CBN appears to have completely changed the structure of its liquidity management operations away from the historically expensive OMO bill securities towards the use of near zero yielding SPEB instruments and zero cost CRR debits. While the reduction of OMO bills is positive for CBN profitability which had been previously endangered, the development makes monetary transmission through conventional OMO operations unclear which could have implications for the future conduct of monetary policy. This perhaps explains the wider spread between primary and secondary market bond yields which has expanded over the last three years – a reprise of the 2009-2010 era where the CBN embarked on a similar low yield strategy to cope with the global financial crisis.
Figure 3: Primary and Secondary Market Bond Yields
2023: The Year Ahead – Higher government borrowings, bear curve steepening
2023 is a year of many transitions. At the global level, after speedy rate hikes to quell inflation, major central banks are likely to apply the brakes to the tightening cycle as a mix of base effects and tight credit conditions drive a slowdown in inflation.
At home, Nigeria is at another inflection point politically with another general election that will see the exit of the Muhammadu Buhari administration for a new government. The absence of strong polling makes the outcome of the election unclear though whichever candidate emerges from the front three, the hand they are being dealt with is a weak one. Between widespread insecurity, a weak fiscal balance sheet and a broken exchange rate system there will be little time for any honeymoon but strong decisive actions which will deliver immediate pain to the very electorate they are presently wooing. Thus, dealing with transitions globally and at home is a key theme for 2023. Staying flexible and waiting for the waves is how to play it.
I will outline key themes that will dominate fixed income market sentiments:
Post-election actions on key economic prices, big adjustments on the cards: In the 2023 budget signed into law, the Budget Office notes that the budget modelled petrol subsidy for six months. Already, the appearance of fuel queues all over Nigeria and the increase in actual prices paid over the regulated level of NGN175/litre suggests the present system is unlikely to hold longer. Thus, the next Nigerian president will need to take decisive action on the existing petrol subsidy (which the Buhari government has cowardly refused to take). To remove the subsidy entirely would require a hike in petrol prices towards NGN500-600/litre which is unlikely whichever president is elected. The dictum, ‘we campaign in poetry and govern in prose’ is a very useful one when it comes to believing Nigerian political campaign manifestos. Thus, my suspicion is that we are unlikely to see a clean break from petrol subsidies but rather a step-wise coping approach wherein petrol prices likely move towards NGN250-350/litre and potentially future adjustments to bridge pricing gaps.
The next key economic action is on the now broken exchange rate regime. The system over the last seven years reflects the obstinate position of the Buhari presidency which found a willing accomplice in the unorthodox economic philosophy of the CBN governor. The next president, without any emotional baggage of attraction to the existing failed system and a new economic management team will likely push for some normalization in the FX system which might see an adjustment in the rate towards NGN550-600/litre and possible return to the pre-2014 exchange rate system abolished by the CBN governor. In the event, the incoming president fails to do neither, we should be prepared for another wilderness style dalliance with heterodox economic policies.
Inflation is likely to be sticky at 18-20%, monetary policy orthodoxy to persist: Ordinarily the presence of large base effects from 2022 would suggest softer inflation trends in 2023. That said, potential adjustments to petrol prices and the exchange rate speak to inflation remaining stubbornly high over 2023 in the 18-20% region. Alongside potential normalization in the exchange rate system, Nigeria will need to keep interest rates at a level that is attractive for both domestic and offshore interest in Naira assets. As such I expect the CBN to remain on the path of orthodoxy. In terms of rate hikes, my suspicion is that the CBN is likely going to slow down on tightening, as with global central banks, and my sense is for only a cumulative 150-300bps moves over the course of the year.
Budget implementation will likely tail the target, but planned domestic borrowings are elevated: Though the 2023 budget was tagged one of fiscal consolidation, this is better read as either a parting joke by the outgoing Finance Minister or a misunderstanding of the meaning of fiscal consolidation. In 2023, the projected fiscal deficit is expected at NGN11trillion (5.03% of GDP) which is higher the NGN8.1trillion (4.43% of GDP) in the 2021 budget. A budget of ‘consolidation’ should imply a lower fiscal deficit. Whatever confused meaning the Finance Ministry was referring to the DMO would need to borrow NGN7trillion via domestic sources to plug this deficit which would translate to around NGN500billion monthly borrowings via bonds/NTB. This is potentially large supply and the DMO will need to pull all tricks to contain yield upside.
The End of Ways & Means, the road away from serfdom: Over the last two weeks, the planned securitization of the CBN Ways & Means advances totaling NGN22trillion has predictably garnered negative attention following the Senate’s refusal to approve the measure. In response, President Buhari has noted that failure would see additional interest expense of NGN1.8trillion for not passing the measure.
To my mind, the arguments over the W&M loans amount to a debate over money borrowed from the left hand by the right hand. In dealing with the blowback from the oil price collapse in 2014-2017 and the COVID-19 pandemic, without going to the IMF, the FGN resorted to borrowing heavily from the CBN, essentially electing to tolerate high inflation from the increase in money supply occasioned by the policy. This policy, alongside Naira devaluation, Eurobond sales and large domestic borrowings was the coping mechanism to adjust the oil and COVID-19 shock. Were there alternative approaches to facing those issues? Yes, but they were always going to be difficult choices and we can only hypothesize about the road not taken with the benefit of the hindsight mirror. The important facts are that those loans have been borrowed, the monies printed and disbursed within the economy. Cleaning up after the fact is what we have called Securitization. Consider the alternative that has been naively suggested in some quarters, that as the loans are illegal, the FGN should not pay. The resulting effect is that the W&M advances will become a giant non-performing asset on the CBN’s balance sheet which will either have to resort to extreme contractionary monetary policy to remain solvent or be recapitalized by its main shareholders (back to the FGN) again likely via fresh borrowings. Right where we started!
That said, there should be consequences for violating the laid down laws and there should be room for criminal prosecution of the main actors in the saga though a more circumspect reading of the law will find obvious gaps that events appear to have overtaken. W&M loans represent the classic deficit monetization via printing money that is often flayed in standard economic texts due to its inflationary implications. And as a friend noted, the start of the TSA system anchored around CBN being the government’s bank might have provided the leeway for the egregious breaches over the last seven years with willing accomplices across the fiscal and monetary aisle. A potential fix might be to restrict the excess of CBN overdrafts to the FGN over FGN deposits in the TSA at a set ratio and mandate that any persistent overdrafts be converted to loans within the next budget cycles. In addition, these measures should include an annual requirement for finance ministers to include in the budget statement that there are no breaches of W&M provisions with a jail term for offenders.
DMO likely to elongate tenors as near maturities cross NGN1trillion mark: In terms of likely maturities, the guidance is for a minimum weighted average tenor of debt of 10-years. My sense is we will likely see a continuation of the 10-year (2032) and 15-year maturities (with a slide down from 2037 to 2038) in the Q1 2023 calendar. This leaves the choice of either going back to 2025 or introducing a new 2030 bond (as 2029 looks full) and the existing 2030 is a heavily discounted bond which is not attractive from an issuance perspective. My guess is possibly a new 2030 paper. What of the mid-point? the DMO will likely be wary of spooking markets, and we may see either an unchanged mid-point at NGN225billion a month or something slightly higher NGN230-250billion with higher actual borrowings at the auctions in line with recent practice.
Figure 4: FGN Annual Bond Maturity Profile
An uneven maturity profile suggests an up-down-up trajectory for yields: So where does all this backdrop leave us for interest rate outlook in 2023? Fundamentally, an expansionary fiscal posture with a large deficit funded by higher borrowings alongside contractionary monetary policy given an elevated inflation profile would speak to a higher interest rate environment over 2023. Technical factors with a large bond maturity (NGN736billion) in April 2023 amid growing monthly coupons totally NGN2.2trillion over the year would provide moments for the occasional liquidity driven yield declines. In terms of the yield curve shape, my sense is for a bear steepening pattern over the year entirely driven by heavy government borrowing. Short term rates will likely remain elevated but not on government securities more on interbank placement rates.
I leave with this quote.
Practical men who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back – John Maynard Keynes
Happy New Year and Good luck navigating 2023!
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