Interest rates were fairly stable over the past quarter compared to the June sell-off. Rates have rallied a little from the high of late August, but the market is still pricing in a 0.5% rate hike over the next year. The Reserve Bank's Monetary Policy Committee (MPC) is definitely more cautious in its inflation outlook, noting the risks are to the upside. If the inflation rate continues to escalate from the current 6.4%, the MPC will be forced to take some action. It is important for investor confidence that the Reserve Bank is seen to be monitoring inflation closely and taking action if necessary. Our base case assumption is that the rand will continue to weaken as global interest rates rise. Rand weakness, together with wage increases of about 8%, means the inflation rate is unlikely to fall back within the target band soon. We therefore expect interest rates to increases and prefer floating rate notes. People often become used to the status quo and fail to look at the historic norms to add context. The repo rate has averaged 8.7% since January 2000, over the same period the inflation rate averaged 5.8%. A rate of 8.7% seems a very long way from the current 5%, but is important to remember that this is just the average when looking at the probabilities of various outcomes.

South African money markets finally saw some volatility over the past month after two and a half years of price stability. Despite the rand weakening 10% from the start of the year to mid-May, investors were discounting an interest rate cut due to consistently weak macroeconomic data. A further 10% weakening of the rand and a sell-off in the bond market as investor confidence in emerging markets waned, caused interest rate expectations to change. At one point the market was beginning to discount interest rate hikes in the short term. Subsequently the rand has recovered somewhat, and the money market yield curve has assumed a more normal shape as opposed to the very flat profile of the past two years and the steepness of mid-June. The indication that the US Federal Reserve will begin to slow its bondbuying programme is very significant for South African fixed interest markets. International investors have consistently bought South African government bonds over the past three years in a search for yield, as the yields on developed market debt have been so low. With US government bonds selling off and the yields becoming more attractive, the flows into our bond market may slow. If the foreign purchases slow or cease the rand may be persistently weak, pushing up inflation. The South African economy is not growing, so the Monetary Policy Committee (MPC) is loath to increase interest rates. The MPC will likely have to see inflation consistently breaching the upper limit of the 3-6% target range before taking action. The steeper money market yield curve now offers some value in the longer dated assets, as investors are paid to take the duration risk. Our assessment that the MPC will increase rates, but not in the short term, means we have begun to buy some assets in the six- to nine-month area of the yield curve, as opposed to focusing solely on floating rate notes.

Interest rates have remained unchanged over the past three months but the outlook has changed slightly, as the rand has depreciated by a further 8% against the dollar, taking the year-on-year move to 20%. The currency weakness clearly puts some upward pressure on the inflation rate. The rising inflation rate makes any interest rate cuts increasingly unlikely. The inflation rate has exceeded the Repo Rate since the third quarter of 2011. This is unusual in the South African context as policy rates have almost always been above inflation. However, the rising inflation rate is not due to excess demand; rather it is the result of structural issues in the South African economy and rand weakness, so increasing interest rates will have very little effect on the inflation outcome. Any policy action the Monetary Policy Committee (MPC) takes will have to be forced upon it by further currency weakness and a sharply higher inflation rate. This is a possible outcome, but the most likely outcome is the status quo will be maintained and the MPC will continue to look through the inflation rate. Fortunately it does not cost anything to position the Fund to do well in a stable rate environment and still be in the position to benefit from a rising rate scenario. We have done this by investing the maximum amount possible in floating rate notes that will reset to higher interest rates in the case of a rate hike.

The period of remarkably stable interest rates continues. The only interest rate change of the past two years was the 50 basis point cut in July 2012. Our view is unchanged in that we think the medium-term risk to interest rates is to the upside. This does not rule out rate cuts in the near term. In the short term a slowdown in domestic consumption could lead the Monetary Policy Committee (MPC) to cut rates. A domestic slowdown could be precipitated by a reduction in unsecured credit growth. The micro loan sector is not interest rate sensitive, but the volume of new advances looks to be getting out of hand, with unsecured advances growing R61 billion over the past year. Total household consumption expenditure was R1 743 billion in 2011, so the growth in unsecured lending is not immaterial in this context. A slowdown in consumption expenditure would reduce the current account deficit, the size of which poses a threat to the stability of the rand and inflation. In this situation the MPC could argue for rate cuts, however lower interest rates could undermine the rand, which is supported by investors who wish to benefit from relatively high South African interest rates. Foreigners invested R86 billion in the South African bond market in 2012. This went some way to financing the current account deficit, which was R144bn for the first nine months of the year. Bonds have been a great asset class for investors; this historical performance has encouraged record flows into global bond funds and more specifically emerging market bonds with higher yields. These flows have helped stabilise the rand. Our concern is that if the bond flows slow down the rand may weaken leading to increased inflation and possibly higher interest rates. The Fund is positioned to benefit from a flat or rising rate environment through its investment in floating rate notes.