For weeks we have been perplexed by one-year Naira-denominated risk-free rates lower than the 250 – 300 spread over inflation which we think foreign investors require. Last week rates moved back up. As we argue on page 2, a soft outlook for US rates does not necessarily mean lower rates in emerging markets, especially if a US slowdown in growth implies weak oil prices.
In the principal foreign exchange market, the NAFEX market, foreign investor participation remains high, providing 52% of liquidity. The three-month moving average figure of the Central Bank of Nigeria’s (CBN) foreign exchange reserves stands at US$45.16bn, a slight increase from the beginning of the month. The underpinning of the Naira, currently at N360.10/US$1, appears strong. If there is a shock to the system – say, oil prices – the CBN has sufficient buffers to absorb it in our view, so we believe the Naira is sound for at least the rest of this year.
Bonds & T-bills
The yield on a Federal Government of Nigeria (FGN) Naira bond with 10 years to maturity increased by 27bps to 14.60%, and at 3 years rose by 26bps to 14.62% last week. The yield on a 364-day T-bill rose by 89bps to 14.09%. The yield on a T-bill with 3 months to maturity rose by 176bps to 12.55%.
Market rates rose last week to lift the spread of one-year risk-free Naira rates above inflation to 272bps. This is within our expectations of a 250 – 300 bps spread. Open market operation (OMO) yields at auction remained flat, suggesting the CBN sees scope for market rates to remain low in the short term.
The price of Brent decreased by 1.86% last week to US$63.29/bbl. The average price, year-to-date, is US$66.58/bbl, 7.13% lower than the average of US$71.69/bbl in 2018, but 21.60% higher than the US$54.75/bbl average seen in 2017.
Last week the World Bank’s publication Global Economic Prospects, June 2019 cut its forecast of global growth in 2019 from 2.9% y/y to 2.6% y/y. With oil inventory levels high there was little to support oil prices at this point. Saudi Arabia, which implemented production cuts earlier this year, is reported to be negotiating with Russia to coordinate efforts to reduce supply. Much depends on the outcome of those talks, in our view.
The Nigerian Stock Exchange (NSE) All-Share Index recorded a loss of 2.05% last week, resulting in a year-to-date return of negative 3.18%. Last week Sterling Bank (+6.52%), Access Bank (+3.28%) and FCMB (+2.48%) closed positive while Dangote Sugar (-12.88%), PZ Cussons (-9.26%) and Seplat (-6.64%) fell.
As we argue in Coronation Research, Power to the price point, 20 May, listed consumer companies, with the possible exception of Nestle Nigeria, face an uphill challenge in expanding market share. Stiff competition from unlisted competitors, exploiting the price sensitivity of the mass market, causes them problems.
US dollar rates and Naira rates
US dollar rates, the key influence in H1 2019
The lesson from late January this year was clear. Once US dollar interest rate increases were put on hold then the carry trade, which for our purposes means borrowing in US dollars and investing in Naira fixed-income securities, became more attractive than before. We noted both the swiftness and the size of US dollar flows into Nigeria from that point onwards. Gross inflows were in excess of US$11.0bn and contributed to a recovery in CBN reserves. Naira one-year risk-free rates fell by some 300 basis points (bps) from just over 17.00% per annum (pa) to just over 14.00% pa.
The next lesson came early this month when the leadership of the US Federal Reserve abandoned its neutral policy stance in favour of accommodating growth in the US economy. In other words, the US Federal Reserve has become less concerned about the inflationary effects of America’s various tariff wars than with the growth outlook and it is prepared to cut interest rates to preserve growth. This was its second big change of the year to date.
US dollar rate cuts now priced in
Around this time US bond markets adjusted, and it seems that a cut of some 100 basis points in US rates by the end of 2020 is being priced in. For emerging markets this can be seen as good news. Lower US yields increase the spread in the carry trade. In practical terms it lowers the cost of US dollar funds for investment funds which reference US dollar Libor. It makes their emerging market fixed-income investments more profitable than before.
So, perhaps it should not have been a surprise to us when one-year risk-free Naira rates fell to 13.45% in late May and then 13.20% earlier this month. These rates compared with recent inflation prints at 11.37% y/y and therefore were short of the 250-300bps spread over inflation which we usually expect to see. Not that we believed it, but for a brief period it looked as though we were in for a period of low Naira rates.
Do not forget about oil prices
However, there is no simple read-through from US rates to Nigerian rates. Risk factors come into the equation. For example, one reason why Naira interest rates were so high at the beginning of the year was the prospect of general elections in February. So it was a combination of removing electoral risk and the hold on US interest rates which caused Naira interest rates fall by 300bps after January.
However, a declining US interest rate outlook is not the only consequence of a poor US economic growth outlook: so too is the global growth outlook and the prospect for commodity prices, including oil. Oil prices are, once again, a risk factor for Nigeria, with crude oil (Brent) ending last week at US$63.29/bbl, down 13.06% from its recent high at the end of April.
There are two reasons to be concerned. The first is that US$60.00/bbl is the oil price given in the Federal Government of Nigeria’s (FGN) 2019 Appropriation Bill (its budget), and with production falling roughly 20% short of the assumed 2.3 million barrels per day (mbpd), there is implied fiscal pressure. Second, and connected to the FGN’s budget assumptions, is the likelihood that foreign investors see an oil price of US$60.00/bbl as level above which they feel comfortable: below US$60.00/bbl they may feel somewhat nervous, in our view. This, we believe, is consistent with upwards pressure on Naira interest rates.