The Monetary Policy Committee (MPC) of the South African Reserve Bank decided to keep interest rates unchanged at the September 23 meeting. When commenting on the decision, the MPC noted that it is concerned about the upside risks to inflation from the weaker rand and that its forecasts anticipate the inflation rate being uncomfortably close to the upper bound of the target range for the next two years. In the face of these inflation risks, the reason for keeping rates on hold was clearly the state of the economy.

South Africa is quite unusual in the global context: price levels are falling in most places, but going up at home. The main reasons for rising prices in South Africa are wages rising steadily at about 7% per year, increasing utility prices and the weaker rand. Increasing interest rates may have a marginal effect on the rand but is unlikely to solve these problems. The underlying cause of the weak rand is the current account deficit. This deficit could be ascribed to excess demand, but consumer demand is already weak. The issue is a lack of domestic supply, weak commodity prices and lower mining production. The rand weakness over the past year seems to be encouraging import substitution to some extent, which will begin to solve the trade account problem. But these structural issues are unlikely to disappear in the near term, so the South African inflation rate is likely to be quite sticky at around 6% per year.

Persistently high inflation will probably lead the MPC to increase interest rates to a level where short rates at least match the inflation rate. But it will probably increase rates slowly so as not to cause a further deterioration in the economy. We continue to take advantage of the steeply sloping yield curve by investing in six- and seven-month deposits, which yield 6.8% per year. Floating rate notes are also good value and have a similar yield to the six-month notes, but will benefit from any interest rate increases. We took advantage of a sell-off in Treasury bills to increase our South African government exposure to 15% of the Fund.

Commentary contributed by Andrew Lapping

The unusual stability of the South African money market continued during the past quarter. Short-term interest rates are basically unchanged since the end of the cutting cycle in November 2010, when the Monetary Policy Committee (MPC) reduced short rates by 6.5% over a two-year period. After the period of stability we have experienced it is difficult to picture a 6% interest rate move, but our minds must be open to possibilities, and the Fund is managed accordingly.

The tone of the recent MPC commentary indicates it would like to increase rates in the near future. However, it is in a difficult position: it is concerned about the upside risks to inflation but at the same time cautious about pressuring the weak South African economy. The market is anticipating increases over the next few meetings, with the six-month negotiable certificate of deposit (NCD) yielding 6.75%, compared to cash at 5.6%.

Unless the rand weakens dramatically, it is unlikely that the MPC will increase rates as fast as the market anticipates because of the damage higher rates could do to the weak economy. If interest rates rise slowly, fixed-rate assets, like the six-month NCD, will be a good investment. However, the risk of a much sharper interest rate rise must be considered, given the steadily falling prices for many of the commodities South Africa exports, and associated risks to the rand. For this reason we keep the Fund flexible, with a mix of floating rate notes, cash and fixed-rate notes. The Fund's duration and asset mix is little changed over the past three months. The duration is slightly lower as the cash and very short duration holdings have increased and the ratio of floating to fixed rate assets has increased slightly.

Commentary contributed by Andrew Lapping

South Africa's underlying inflation rate, i.e. the structural cost increases that businesses and consumers experience, is about 6% p.a. This number is surprisingly stable compared to the swings of the headline Consumer Price Index (CPI) number, which includes volatile components like the fuel price. The underlying inflation rate can be seen in the services components of the CPI basket, which includes price items relating to hotels, education and medical care. It also reconciles with the Reserve Bank's estimates of wage increases of 7.7% p.a., offset to some extent by productivity gains, to give a unit labour cost increase of 6.2% p.a.

Reading the statement of the Monetary Policy Committee (MPC), it is clear that the Committee thinks the repo rate of 5.75% p.a. is too low. It would like to increase rates, but it is difficult in the face of our weak economy. The stubbornly high underlying inflation is not because of excess demand, but rather due to structural issues in the economy. Higher interest rates will not address these structural issues. The MPC will probably increase rates later this year as it moves towards 'normalisation'.

The money market yield curve is steep, with the six-month negotiable certificate of deposit (NCD) at 6.75% p.a. compared to cash at 5.5% p.a. We think the yield on the six-month NCD more than compensates investors for the potential interest rate increases over the period. For this reason, we are still buying six-month NCDs and 12-month floating rate notes. These assets, together with the cash holding, provide a good yield while keeping the Fund's interest rate risk low and liquidity high.

Commentary contributed by Andrew Lapping

The past year was a surprisingly uneventful one in the money market arena. After selling off in early January with the 0.5% interest rate hike, term interest rates were remarkably stable for the remainder of the year. Throughout the period the money market priced in interest rate increases, but the Monetary Policy Committee of the Reserve Bank only made one further move of 0.25% in July.

We implemented a very similar strategy throughout the year, taking advantage of the steep yield curve by buying six-month NCDs and 12-month floating rate notes to making the best of the banking sector's need for term funding. This strategy allows us to maintain a liquid portfolio and receive a decent yield, while taking limited duration risk. During the third quarter, market participants bid up Treasury bills to a level where purchasing the asset no longer made sense from a value perspective. As a result, our Treasury bill holding fell to below 5%. Pleasingly, the three-month Treasury bill rate has normalised and we have begun to increase our holding.

We still think the inflation and interest rate risks are skewed to the upside because of the imbalances in the South African economy, as discussed in the September commentary. In the short term, there is no doubt that the sharply lower oil and food prices will reduce the inflation rate. The only problem is that weak emerging market demand is one of the reasons for these lower oil prices. Weak economic growth in emerging markets often makes investors negative on the asset class as a whole. This plays out in declining equity prices and currencies. The rand has held up relatively well over the past three months as other emerging market and commodity currencies have weakened.

We will continue to manage the Fund to limit both credit and duration risk while maintaining a very strong liquidity position. This means we will continue to follow the same strategy as we did in 2014, unless the risk/ reward profile of the money market changes.

Commentary contributed by Andrew Lapping