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Interest Rates - Volatile Monetary Policy!

By Cannon Asset Managers (Cannon Asset Managers)
Comments Tuesday, August 02, 2011 at 5:37 PM EAT

Interest Rates - Volatile Monetary Policy!

The Monetary Policy adopted by the Central Bank of Kenya (CBK) since January has been sending conflicting and contradictory signals. At the Monetary Policy Committee (MPC) meeting held on 27^th July, the Central Bank Rate (CBR) was left unchanged at a level of 6.25%, much against market expectations of an increase of 0.25% to 0.50%. We have tabulated below the observations and the policy actions taken on the monetary policy front since January 2011.

Date	Observations/ Comments	Policy Action
27^th January 2011	Overall inflation of 4.5% for December was below the target of 5% No foreseen upside risks to inflation in the near term	CBR lowered by 0.25% to 5.75%
22^nd March 2011	Concerns that previous temporary shocks (oil prices) to domestic prices have become persistent and may have long term effects Need to address these concerns to stop inflationary pressures from becoming more permanent in the economy.	Tighten monetary policy stance by raising CBR to 6%. Decision to raise CBR reflects a change of monetary policy stance and sends the signal that temporary shocks such as exchange rate volatility and seasonal food shortages should not be allowed a persistence that will be built into pricing structures.
31^st May 2011	CBR has effectively coordinated changes in expectations in the various markets Growth of inflation has decelerated and exchange rate was responsive to the policy Short term rates have increased as expected, and now reverted to stable levels and less volatile.	The committee continues to endorse a tight stance so that inflation expectations are tamed and exchange rate stability enhanced. Cash Reserve ratio increased by 25 basis points to 4.75% CBR raised by 25 basis points to 6.25%
29^th June 2011	Inflationary expectations have given rise to some persistent instability which requires immediate actions through robust liquidity management There is need to minimize arbitrage activities in the interbank market.	Interest rate for the CBK overnight discount window delinked from the CBR Overnight interest rate to be reviewed from day to day Overnight interest rate initially set at 8.00%
12^th July 2011	In support of tight monetary policy stance that CBK has been implementing to rein in inflation, CBK has found it necessary to further review guidelines on use of the discount window.	Conditions imposed on use of discount window by commercial banks. With quantities having been restricted, the discount rate will revert to the CBR rate of 6.25% Banks advised to consider liquidating portfolios of Treasury bills, bonds and foreign exchange positions.
27^th July 2011	Committee was concerned with persistent inflationary pressures and exchange rate volatility driven by further supply constraints and heightened expectations Direction and volatility of the exchange rate in recent times was not driven by fundamentals. Tight monetary policy stance would not achieve the desired results at the moment if the supply sides of food, fuel and energy were not effectively being managed to signal relief to the constraints guiding inflationary expectations Broad money supply has been below its target since September 2010.	Committee decided to retain the CBR at 6.25%. In order to facilitate commercial banks liquidity management, banks will be required to maintain Cash Reserve on a weekly average basis instead of current daily average.

As per the Central Bank’s Monetary Policy Statement of December 2010, the Minister of Finance restated through a letter the Government’s overall inflation target of 5 percent to be maintained by the Central Bank of Kenya. With inflation currently standing at almost 3 times the target and with inflationary pressures unabated, it is our opinion that the CBK needed to and should have increased the CBR. Managing the supply sides of commodities are challenges for other arms of the Government, and if they are they are under-performing, it cannot be a reason for the CBK not to fulfil its mandate. Further we have reviewed the performance of the broad money supply against targets (see table below), and we do not believe the deviation is sufficient for the CBK to review its monetary policy stance.

Kenya Broad Money (M3) Performance - Targets versus Actuals
	Sep-10	Oct-10	Nov-10	Dec-10	Jan-11	Feb-11
Target -KSH bn	1,240.2	1,253.9	1,267.7	1,281.6	1,300.3	1,318.8
Actual - KSH bn	1,243.6	1,254.5	1,258.8	1,272.6	1,290.5	1,324.7
Deviation - KSH bn	3.4	0.6	- 8.9	- 9.0	- 9.8	5.9
Deviation - %	0.27%	0.05%	-0.70%	-0.70%	-0.75%	0.45%
Source: Monetary Policy Statement - December 2010, Monthly Economic Reports - January 2011, February 2011

At the current levels of inflation and the outlook for the next few months, we believe that the level of 8% for the overnight window, which was in effect for approximately 2 weeks was an appropriate rate, and the CBR will need to be raised to this level before inflation is tamed and the exchange rate stabilized. Whereas volatility in markets is to be expected, lack of consistency in the monetary policy will only prolong the period as well as the extent of volatility in the interest rate and the exchange rate markets.

We would also like to contrast the actions of the CBK with the stance taken by the Nigerian Central Bank, which increased its benchmark rate by 0.75% on 26^th July 2011, the fourth increase in the rate this year. The statement from the Central Bank accompanying the rate decision stated that the bank “needed to correct the negative interest rate situation in the market and attract foreign capital inflows to build reserves.” This action followed a drop in the inflation rate for June 2011 to 10.20%, the lowest level in 36 months.

Bond Yields and Outlook

The Central Bank auctioned a 2-year and a 10-year bond last week. The bidding for the bonds by market players was at extremely high rates – average rate bid for the bonds were 13.47% and 13.62% for the 2-year and 10-year bond respectively. The CBK accepted only 52% of the bids at average rates of 12.68% and 13.09%.

In our previous newsletter, we had commented on the distorted shape of the Yield Curve published by the Nairobi Stock Exchange, and offered an alternate yield curve to help players carry out a mark to market of their books for management purposes. We are delighted to see that the NSE has removed the distortions from their yield curve last week, and now has a yield curve which is upward sloping, but extremely flat at the long end. We believe the yield curve is reasonably representative of the actual market conditions. The chart below shows the movement of the NSE yield curve from December 2010 to 31^st March 2011 as well as at 22^nd July. The distorted yield curve of 30^th June 2011 is also included for comparison.

The yield curve currently has an extremely flat shape which we believe is not sustainable. The flatness has resulted from the CBK’s willingness to pay higher rates at the short end of the curve (>12.50% for the 2 year bond) while refusing to pay higher rates on the longer end (<13.25% for the 10 year bond). We forecast that the yield curve will steepen in the next 2-3 months, under one of the following scenarios:

Scenario 1 – Optimistic: The CBK is able to manage the short-end rates and guide them lower, with the 91-day Treasury bill rate falling to a level of 8.00-8.50%. The yield curve steepens with a fall at the short-end of the curve.

Scenario 2 – Pessimistic: The CBK is unable to raise sufficient funds and is forced to accept bids at higher rates at the longer end of the curve. The yield curve steepens with an increase in the long-end of the curve.

Prior to the recent announcement by the MPC, we considered Scenario 1 as the more likely scenario, and were positioning our client portfolios accordingly. However we have now revised our views and we believe that both scenarios are equally likely, and will therefore be standing aside for the short term.

Labels:

Bond Yields, Central Bank, Central Bank Rate, inflation, Interest Rates, monetary policy, Nairobi Stock Exchange, Yield Curve

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