Topsy curvy

South Africa has been mostly spared the torrid conditions experienced elsewhere across the globe during the past year, a result of the global credit contagion spread by souring US subprime mortgages. The local fixed-income market, however, has been far from quiet.

A series of surprise events has sent interest rates cartwheeling in recent months. From the end of May, hawkish remarks by the central bank governor, combined with a rethink in the way inflation is calculated - and an ensuing war of words between the country's main statistics agency and one of its biggest asset managers - have given major market participants a white-knuckle ride. Markets have been shaken up dramatically, while onshore and offshore hedge funds, asset managers and local swap dealers have all had their nerves tested.

"If anyone says they've made a lot of money in all this, I think it's down to being lucky and it will certainly not be a lot of cash. These markets have really been tough," reflects Johan Roos, head of interest rate derivatives trading at Standard Bank in Johannesburg.

Like many others across the globe, South Africa's economy has been bedevilled by inflation during the past year. Upward trends in energy and food prices have helped push the country's main target rate, the consumer price index excluding interest rates on mortgage bonds (CPIX), to a five-year peak. In March, the CPIX hit 10.1% - the first time it had breached the 10% mark since January 2003.

For the South African Reserve Bank, March represented the twelfth consecutive month for which inflation had lingered above its target bracket of 3-6%. And the situation worsened the following month, with the CPIX rate for April rising to 10.4%. The publication of this figure, 4.4 percentage points above the Reserve Bank's target band, prompted governor Tito Mboweni to make some particularly hawkish remarks about interest rates during a speech at the Gordon Institute of Business Science in Johannesburg on May 28. Specifically, he hinted the central bank could embark on a 200 basis-point hike.

"It wasn't that he said they would definitely raise rates by 200bp; just that if they had to raise interest rates by 200bp, they would," insists a Reserve Bank spokesperson.

In spite of the dire warning offered by Mboweni, the Reserve Bank raised the repo rate by just 50bp to 12% on June 13. Nevertheless, the prospect of such a drastic rate hike had already sent the market into a tailspin. "We had this massive jump in yields and the rates and bond markets went crazy," says Clinton Clarke, Johannesburg-based head of fixed-income sales at Absa Capital.

From 10.924% at the close on May 27, the yield on the South African government's R153 benchmark bond due in 2010 leapt to reach 11.621% by June 2.

The interest rate markets were further shaken on July 1, when South Africa's national statistics agency released a wealth of changes to its CPIX measure. The alterations, which will take effect from January 2009, include updating and re-weighting the basket of goods included in the CPIX, as well as rebasing the index. The net effect could be an average decline in the main targeted inflation rate of around two percentage points, according to local analysts.

"There was initially a lot of confusion when that came out," says Jay Naidoo, head interest rate swaps trader at Nedbank Capital in Johannesburg. Having skyrocketed through June, rate expectations were adjusted drastically in the opposite direction. The downward trend in rate expectations was further stoked by a statement from Investec Asset Management on July 15, which accused Pretoria-based Statistics South Africa of failing to calculate the CPIX correctly. The statement brought back memories of 2003, when the asset manager discovered a mistake in the agency's CPIX calculation that caused inflation to come in higher than it otherwise should have.

This time, however, the asset manager simply accused Statistics South Africa of being late in revising its methodology. "Substitution effects and rising incomes can materially change consumer spending patterns over time, (so) international best practice is to re-weight and rebase consumer price indexes every five years," the Investec statement said. "By not doing so last year, five years after the previous recalculation, we estimate the CPIX will now peak about three percentage points higher than it should have done if calculated correctly."

The announcement created more chaos throughout the market, explains Naidoo at Nedbank Capital. "That spooked the swaps market more than ever. What happened thereafter was an extreme lack of liquidity and the market was pulled a lot lower very quickly, which left a lot of people in pain."

Having peaked at 11.835% on July 1, the yield on the R153 bond dropped to 9.627% by August 18, reflecting the quick shift in the outlook for inflation and rates. The ferocity of the moves caught many in the market by surprise, including local pension funds and asset managers, which have reportedly scaled back their bond allocations in recent years.

"Asset allocation to bonds on average slowed down to anywhere between 9-7% over the past two or three years, where the long-term average probably is closer to 14-17%," says Erik Nel, Johannesburg-based co-head of fixed income, currencies and commodities sales at Rand Merchant Bank (RMB).

Prior to the rally in bonds, asset managers had been underweight fixed income in a deliberate effort to outperform their benchmarks, says Roos of Standard Bank. "Many asset managers have been correct in their thoughts that by being short the benchmark with rates kicking up so aggressively, they would perform better than the actual benchmark. But with the market rallying like this, they need to get a lot closer to the benchmark, and fast at that."

Consequently, the rally across fixed income triggered a scramble to buy bonds. But bankers believe many asset managers and pension funds were disappointed and still remain relatively underweight compared with their benchmarks.

The shift in the yield curve also had some tangible effects on positioning by local and offshore hedge funds, as well as real money accounts. In particular, many investors had put on positions allowing them to benefit if the yield curve - already inverted - continued on this trend, primarily by receiving 10-year swaps and paying two-year swaps.

These trades had performed well over the past 12 months, with the spread between two-year and 10-year swaps (2s10s) widening from -87bp on September 17, 2007 to a peak of -197bp on May 29 this year. Changing interest rate expectations, however, caused the curve to flatten quickly in June, with the 2s10s spread narrowing to -100bp by July 10.

This shift in the curve was exacerbated by the unwinding of now-unprofitable inversion trades by hedge funds, adds Absa Capital's Clarke. "Many accounts had inversion trades on - and those are trades that had previously made a lot of money for them. They came in and the unwinding activity just exacerbated the change in curve shape as two-year versus 10-year steepened."

In fact, so sharp was the move that there was interest from hedge funds and others to put on steepener trades, says Roos of Standard Bank. "We saw a lot of people paying 2s10s, expecting the curve to steepen up quite aggressively. But it hasn't really come to fruition," he says.

Indeed, the 2s10s spread has been extremely volatile since early July reflecting uncertainly in the interest rate outlook, widening to -172bp on July 30 before tightening in to -120bp on August 20. The 2s10s spread has since widened out once again, reaching -159bp as of September 9.

Absa Capital's Clarke says another popular trade for hedge funds and real money accounts was paying one-year forward-starting swaps (1y1y) in the expectation that rates would rise. These positions caused pain for many hedge funds and real money accounts as 1y1y rates spiked and then collapsed with the decline in future rate expectations. From 11.85% on May 27, swap rates had increased to 12.55% by July 1. Levels on 1y1y forwards later decreased to 9.64% by August 18, as yields on the R153 bond similarly dipped. Part of the reason for this reversal in 1y1y was a shifting of positions by hedge funds and real money accounts into 1y1y receivers, says Clarke.

Others in the market also believe the sharp moves were accentuated by unwinding activity from hedge funds onshore and elsewhere. "It looks as though there were a bunch of macro emerging market hedge fund trades that were put in place, and as South African hedge fund managers started to react, some of those macro trades started to unwind," says one head of trading at a large South African insurance company.

One thing is certain - neither dealers nor their clients have had an easy ride. Turbulent bond and swaps markets and scarce liquidity are thought to have caused losses for some trading desks. At various points from late May to early August, the bond market moved in spurts of 30-50bp, bankers say, while getting prices on swaps was sometimes difficult. "Some of the moves were almost straight-line moves and it's never easy to be on the right side of that being market makers," says RMB's Nel. Although the difficulties were invoked by a very particular set of local circumstances, he sees them as a continuation on a global theme. "It's been a tough year's trading everywhere around the world, and the global credit crunch has made it difficult to fundamentally get things right," adds Nel.