Kim Silberman, Macro Economist and Fixed Income Strategist at Matrix Fund Managers
Monetary policy uses the policy rate to drive the inflation cycle around a targeted rate. However, changing the target can permanently lower inflation and inflation expectations, impacting not only short term rates, but also longer-term bond yields via inflation expectations. If a central bank is credible, lowering the target can reduce the fair value of bond yields.
Nominal bonds rally on MPC’s lower inflation expectations
In May, the Monetary Policy Committee (MPC) voted to lower the policy rate by 25 basis points (bp) to 7.25%. The statement also showed that the South African Reserve Bank’s (SARB’s) Quarterly Projection Model (QPM) lowered inflation by a significant 40bp for 2025, from an average of 3.6% to 3.2%, and by 30bp for 2026 from 4.5% to 4.2%. According to the statement, these downward revisions reflect a stronger exchange rate assumption, lower oil prices, and the cancellation of the proposed VAT increase. These factors are expected to offset the higher fuel levy announced in the Budget.
All else being equal, a downward revision of inflation forecasts should fuel expectations of a lower policy rate, steepening the yield curve. This is because the front end of the curve is more sensitive to policy rate expectations, while the back end responds more to long-term inflation expectations.
However, since May’s meeting’s the yield curve has flattened i.e. the long end rallied by more than the short end. We believe that this unorthodox response illustrates the unique benefit to bonds of lowering the inflation target, as opposed to just the inflation forecast. In the absence of structural changes to growth, structural changes to inflation – such as lowering the target – may be the only meaningful way to assist with national treasury’s debt service costs.
Key to lowering bond yields is keeping the real rate elevated As part of the May MPC statement, the SARB released a scenario in which the inflation target is lowered to 3.0% from the current 4.5%, outlining the associated path for rates and inflation (Figures 1 and 2). The SARB confirmed that the 3.0% inflation target scenario will be updated and released at every MPC meeting going forward.
Currently inflation averages close to 3.0%. Under this scenario the SARB’s CPI forecast remains nearly flat until the end of 2027 and is 140bp below the terminal CPI rate projected under the 4.5% target (Figure 1). This more benign inflation outlook allows for a lower nominal policy rate trajectory (Figure 2). By the end of 2026, the policy rate is estimated to be a cumulative 105bp lower than under the prevailing 4.5% target, and by the end of 2027 it is projected to be 131bp lower (Figure 3) i.e. under a 3.0% target scenario, the policy rate would end 2026 at 5.85% as opposed to 6.90% under the current 4.5% target (Figure 2).
While nominal rates are expected to fall by more in a 3.0% scenario, the real rate – interest rates adjusted for inflation – will need to be higher. Under the 3.0% scenario, the real rate is 37bp higher in 2Q26, after which both scenarios forecast real rates falling to 2.8% (Figure 4).
Theoretically, if inflation forecasts are revised lower, markets anticipate policy can be more accommodative/less restrictive, with rates falling faster than inflation, causing real rates to decline. However, if instead markets believe that the central bank will raise real rates even as inflation forecasts fall – rendering monetary policy more restrictive – then the front end of the curve will remain relatively elevated, and breakeven inflation should compress as nominal yields decline relative to real yields.
Post the May MPC meeting, the latter scenario played out. The release of the scenario and the speech’s emphasis on the SARB’s intent to lower the target, increased expectations that it would indeed be adjusted lower sooner rather than later. This saw the bond curve rally and flatten, with front end yields decreasing by 25bp and long-term yields by 40bp. In addition, both 10-yr and 5-yr breakeven rates fell to their lowest levels since 2021 (Figure 5) as nominal yields fell and inflation linked bond yields rose marginally (Figure 6).
We believe that the SARB’s inflation forecast in the 3.0% scenario is optimistic. Our own and consensus CPI forecasts are for inflation to average 3.8% in 2026. Both our internal projections and broader consensus estimates indicate that CPI inflation is likely to average 3.8% in 2026. Nonetheless, we expect the SARB’s real policy rate forecast to materialise and be maintained at or above 3.0%. Assuming an inflation rate of 3.8%, this would permit cuts of 25bp to 50bp, which is in line with markets, as interest rate derivative are fully priced for a cut at the July meeting.
A virtuous circle
The announcement of the SARB’s intention to adopt a 3.0% inflation target has triggered a disinflation process by lowering inflation expectations and may be one of the few ways the Reserve Bank can sustainably effect a long-term structural change in bond yields. Moreover, the SARB has published research which shows that sustained lower inflation supports fixed investment by lowering the risk to returns associated with high and volatile inflation. This should eventually have a positive effect on GDP growth and fiscal metrics. With respect to this virtuous circle, it is interesting to note that the SARB has stated that “the implicit rates goal should be a neutral nominal repo rate of about 5%, reflecting a lower neutral real rate, achieved in large part by a lower country risk premium.”
ENDS
