The Week that was (Feb 1-5, 2021)
Key highlights were the surprise hike at the OMO auction and the devaluation along NDF contracts. In terms of interest rates, the front-end remains pressured due to turmoil across money markets where liquidity levels have been tight recently while across the long end, markets have calmed with bulls gradually asserting dominance after a month of bearish sentiments.
Money markets remain tight: Financial markets remained tight for the second week in a row with overnight/OBB rates averaging 12.48 and 12.15% respectively (vs. 7.65% and 6.95% in the prior week). The levels over the last two weeks contrast with subdued patterns (1-2%) over the first three weeks of 2021 and reflect pressures on system liquidity occasioned by CRR debits and a step-up in FX auctions. Curiously, the pattern comes despite net liquidity injections looking at maturities (demand) relative to issuance (supply) across the three risk free instruments: NTB (+NGN127billion), OMO (+NGN1.1trillion) and FGN bonds (+NGN69billion). This suggests that CRR debits have been quite excessive given that CBN’s FX auctions have not been significantly large.
CBN hikes OMO rates, return of the FPIs? On Thursday, at the OMO auction where there was an offer of NGN100billion (less than the recent NGN150-170billion pattern), the CBN elected to clear the auction at the highest bid rates resulting in a jump in stop rates (on average +467 bps) with the 1-yr paper closing at 10.10% (effective yield: 11%). Given tight money market conditions which had strained banks’ ability to participate at these sales, demand at the auction was muted with bids of only 72% of the amount on offer, which would suggest that the bulk of participants were likely foreign portfolio investors. The move likely reflects a desire by the CBN to offer attractive yields to offshore investors for two objectives: to help rollover near term NDF maturities and to cultivate fresh inflows to help shore up the NGN.
Bond yields calm after last week’s sell-off but OMO auction sets a cat among pigeons: Though FGN bond yields closed higher, markets had turned bullish with the long end yield approaching sub-10% levels after the sell-off in the prior week. However, markets turned bearish again following the hike in OMO stop rates possibly reflecting increased activity by shorts intent on driving yields higher. However, it appears a lot of pension funds in breach of variable income limits have front-loaded their sales in late January. On the deadline itself, there was on update from PENCOM which affirmed March 5, 2021 as the date for pension funds to rebalance their MTM bond holdings to within limits. Interestingly, the regulator has imposed more stringent guidelines for bond re-classifications which limits these going forward which under a backdrop of rising interest rates has positive implications for bond demand. However, banks and asset managers, with no limitations in shorting, will continue to try to engineer yields higher looking at their near synchronized chorusing about higher bond yields post the OMO auction even though these instruments exist outside the investment universe of non-bank domestic investors given CBN restrictions.
Figure 1: Naira yield curve
Source: FMDQ, NBS
NDF devaluations signal near term NGN depreciation: In between the OMO auction ruckus, CBN weakened the strike rate on Naira based Non-deliverable Forward (NDF) market by around NGN15/$ or 2.3% across the curve. This development, on the heels of a similar move in December 2020, likely presages a near term devaluation of the spot rate towards NGN410-412/$. To understand what is going on, I reverse engineer the forward interest rate parity condition to solve for the implied NGN yields on the NDF curve. From my analysis, the implied yields using the spot rate of NGN396.17/$ hovers between 14.4-14.8% for 1-5yr maturities (See Table 1 below), with the range at a premium to the actual NGN yield curve, where rates are between 2-7.5% for 1-5yr risk free instruments. This upward adjustment in the NDF curve will have to be accompanied by a weakening of the spot rate to make sense. Using the last OMO auction stop rate, the most likely spot rate is NGN410-412/$, but whether this will be enough to incentivize offshore investors is a different thing. On the face of it, given sizable NDF maturities over Q1 2021, the CBN play is to try to help induce FPI to rollover for another year.
Table 1: Implied NGN yields on the Naira NDF
Source: FMDQ, US Department of Treasury
For domestic investors, does this mean scope for an upward re-rating in the NGN yield curve to reflect the implied yields on the NDFs? The answer to this depends on whether one thinks CBN is ready to end the bifurcation of fixed income market it introduced in November 2019. If yes, then an upward re-rating should happen soon, but given the large fiscal borrowing requirement and dovish comments by the CBN governor at the January MPC, that prospect appears distant.
Final money supply data for 2020, a year of accommodative monetary policy: CBN released data on final monetary aggregates for 2020 which showed that money supply (defined in Nigeria as M3) expanded by 11.2% over the year (2019: 4.2%). In contrast to other countries, Nigeria uses M3 as the key measure of money supply which is defined as broad money (M2) + CBN bills. M2 is defined as narrow money (M1) plus quasi money (time and savings deposits). M1 itself is a combination of currency outside banks and demand deposits.
Figure 2: Money Supply and its components
Now that we are done with terms, the pick-up in money supply growth over 2020 reflects strong growth in M2 (+32%) which was tempered by the drop in issuance of CBN bills (-88%) following the ban on non-bank domestic investors from participating in OMO bills. That move unleashed NGN5.2trillion worth of liquidity which largely flowed into demand and savings deposits and helped support a double digit expansion in credit growth. From a structural perspective, currency depreciation fueled a larger share of the growth in money supply (+7%) given the drop in FX reserves over 2020 in USD terms relative to expansion in net domestic assets (+4%) resulting in the 11% growth in overall Naira supply. Aggregate CRR debits shrank to NGN9.9trillion (November: NGN12.3trillion) after CBN introduced Special Bills in December.
Over 2021, money supply growth is likely to be more muted reflecting a lukewarm bank approach to credit expansion as banks appear to betting that CBN cannot sustain the low interest rate regime amid the aggressive CRR debits. Perhaps the key conclusion is that monetary impetus is not the driver of the current inflationary bout which remains cost-push driven.
The Week Ahead (Feb 8-12, 2021)
Will the CBN replicate OMO trends for local investors? In the week ahead, NTB maturities total NGN170billion which the CBN will look to rollover, on behalf of the FGN, at Wednesday’s primary market auction. Debt markets are likely going to look to bid aggressively (~7-10%) at the auction in a bid to force the NTB auction yields to reflect the recent OMO auction level. Given the redemption card played at the last two auctions, this auction is a key inflection point as in the event that the yields mirror OMO levels, bond yields will have to shift higher. In the event that the CBN calls the market’s bluff and undersells, then yields remain range bound. In my view, the CBN is unlikely going to want to yield much ground given the implication of a high stop rate at the NTB auction for longer dated bonds.
Bear curve steepening on the cards: At the start of the year, my thesis was for a combination of higher fiscal borrowings and FX-linked pressures to induce a push-up in yields over H2 2021. However, as in 2016, it appears that events are conspiring to bring forward this view into H1 2021. At the heart of this was the PENCOM’s circular to pension funds on rebalancing MTM positions to within limits alongside CBN’s front-end tightening via CRR. The average term premium across the yield curve is now at its elevated levels implying significant market uncertainty over interest rate direction. While the front-end of the curve could as yet remain under some form of monetary policy control, it would appear that bond vigilantes look set to force the long end higher given prospect for higher domestic borrowings which points to a bear curve steepening outlook over 2021. The long end likely runs ahead reflecting market pricing for monetary tightening at some point vs policy makers no-rate increment posture over the near term. Who will win? We may get firmer clues at the NTB and OMO auctions this week.
Figure 3: Average term premiums
Source: Authors calculation