June 2017 Inflation: Headline reading positively surprises, but no respite for bond market bulls

Softer food inflation induces a slowdown in monthly inflation

On Monday, the National Bureau of Statistics (NBS) released the June 2017 inflation numbers and contrary to my call for a sticky number at 16.3% y/y, headline inflation declined for the fifth consecutive month to 16.1% y/y. (May : 16.3% y/y). In recent readings, inflation had been dragged lower by base effects from 2016, when fuel prices and electricity prices were raised. This is important as monthly inflation had been accelerating largely driven by higher food prices. Given the recent naira appreciation, the stubbornly high food prices were difficult to swallow but from the June readings, that resistance appears to have been broken. In June, monthly food inflation decelerated 50bps which underpinned a pullback in monthly headline inflation to 1.58%. In my view, part of the moderation in food stems from cheaper energy prices in particular diesel (down 17% in the last four months) and kerosene (down 30% since February) on account of a naira appreciation at the parallel market where these items were being sourced. That said the monthly inflation reading remains elevated due to higher regional demand for Nigerian goods which has pushed Benin and Togo into deflation.

Figure 1: Contribution to monthly inflation

Contribution to monthly inflation

Source: NBS

Underlying inflation picture remains tame

As earlier stated, headline inflation remains largely driven by food inflation on account of the extra regional demand-pull on local food supplies. NGN is down close to 45% in the last 18months while our neighbours using the CFA franc has strengthened against the USD in line with its Euro peg.  Thus if one excludes these shocks to look at underlying core inflation i.e. Non-Food Non-Fuel inflation (not what NBS calls core inflation which is actually Non-Food inflation as it includes fuel prices), the current number which stands at 12.02% y/y implies underlying inflation remains subdued. The weak pattern sits well with the recession in the economy and the contraction in both measures of money supply over the first five months of 2017: M2 (-25.7% annualized) and M1 (-17.7% annualized). In addition, the elevated interest rate environment has resulted in a contraction in credit to the private sector (-7.6% annualized) while credit to government is up 17% using latest CBN numbers.

Inflation trajectory less sticky on lower energy prices.

While my earlier worries about the lower base effects in the second half of 2017 made me a bit cautious about inflation trajectory, the lower than expected June reading implies I’m now less fearful. Inflation in Nigeria is historically larger in the January-June period as the main harvest occurs in the second half so seasonally we are going into the lower inflation period (see chart 2 below). The rains this year have been good and higher food prices means cultivation is much higher than in prior years. Accordingly, I feel confident to lower my forecast for inflation over H2 17. I’m now looking for a year inflation at 15.5% y/y. For July, I’m sticking the lower base means inflation should decline but only modestly to 16.04% y/y. Will look to update it over the month as diesel prices are in free-fall now.

Figure 2: Average monthly inflation (H1 vs H2)

Average monthy inflation (H1 v H2)

Source: NBS

CBN tightening and rising bond supply to cloud debt market views on inflation

What will fixed income markets do with tamer inflation? Theoretically, lower inflation should make bonds bullish which implies lower yields. But with the CBN continuing to wage war against system liquidity, short-dated government securities have remained unchanged at 19-23% yields in the secondary market. This becomes a hurdle rate for any bond investors faced a slew of investment options with which to defease long term liabilities. Indeed bond yields have started to rise across primary and secondary markets.

Notably, at the last July auction, while the average marginal rate tracked 5bp higher to 16.25, the upper range of bids was roughly 200bp lower suggesting markets were not necessarily demanding a higher premium.  Rather I think thinning system liquidity at the long end, as PFAs appear to have largely deployed funds from April’s FGN 2017 redemption, is driving a re-calibration of views. Having dislodged the liquidity headache over May-June, I think PFAs should now start applying the return on the one year NTB as the hurdle rate for any bond investment for fresh inflows.

Furthermore, while the currency has firmed, outlook remains precarious due to volatility in oil prices implying steep declines could suddenly resurrect fears about pass-through inflationary pressures. Furthermore, a host of borrowers are starting to emerge starting from the FG to Lagos state and likely Dangote Cement after it got a debt rating. Summing it all together, it would appear the only way is up for bond yields. I think things are likely to pick up slowly over July-August and at a much faster pace into September. Should the CBN maintain its ongoing scorched earth policy on liquidity I think there’s real possibility we could sail over 17% in H2 17. Short dated rates should remain trapped in the 19-23% dead-end.

Figure 3: Headline inflation: Actual and Forecast

Annual inflation

Source: NBS, Author’s computation

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