Nigeria Fixed Income Weekly

The week that was (September 6- 10)

A surprise hike on the 1-yr stop rate at the NTB auction drove largely bearish trends across the fixed income market. Elsewhere the Naira continued to test fresh lows at the parallel market as supply across domestic FX markets remain thin.

NTB Auction: A return to the path of convergence? At the fortnightly T-bill auction where the CBN, on behalf of the DMO, had NGN138billion worth of short-term debt to refinance, there was little apprehension that the outcome would buck the declining trend observed in stop-rates since July. It was supposed to be a nothing-burger T-bill sale. However, the DMO delivered a surprise hike in the yield on the 1-yr T-bill to 7.2% (6.8% previously) even as it maintained its pattern of overselling with a total of NGN209billion sold. The over-sale suggests that the move to raise stop-rates was deliberate, as the auction did not need to close higher and did damage to the lower borrowing thesis pushed around much of the market in respond to the pending Eurobond sale.  In last week’s post, I had noted that as the first NTB sale since the CBN resumed its weekly OMO bill auctions, there was an outside chance of a resumption of the convergence game between NTB and OMO yields which dominated T-bill markets in H1 2021.

So what informs the hike? Word on the street appears is that the divergence poses a problem as foreign holders of OMO bills who get these instruments at primary market (stop rates 7-10.10%) promptly move to dispose of these positions at a profit in the secondary market as where these instruments trade at lower levels (stop rates: 4-6.4%). This riskless trade is aided by the fact that the comparable instrument (NTB) which both foreigners and banks can purchase trades at much lower levels. With the resumption of OMO auctions, the only solution to close out the arbitrage is to level up the rates between the NTB and OMO bills. This suggests this convergence trend is likely here to stay.

Fall-out of NTB auction drives sell-off across debt markets:  In response to the NTB outcome, fixed income markets promptly turned bearish with sell-offs across the curve: bond yields sold off 20-35bps with the long end clearing 13.05% on Thursday with bids at 13.1%. Action along the belly of the curve was a bit more restrained but the on-the-run 2036s, which had rallied earlier in the week to 12.2% was trading at 12.7-8% by the close of the week.

Figure 1: Naira Yield Curve

Source: FMDQ

Naira weakens further at the parallel market: In the formal FX segment, average daily turnover at the IE window moderated (-33% w/w to USD141million) after the spike in the prior week as CBN flows normalized. However, no change in exchange rates as the Naira continued to trade rangebound USD410-412/$. Elsewhere, despite continued improvement in FX reserves (+1.5% w/w to USD34.8billion), the Naira weakened at the parallel market, plunging to fresh lows of NGN545/$ (down 2.8% w/w). The development suggests that CBN’s action to cut out BDC increasingly looks more like USD rationing as the USD supply to other segments remain thin. Looking at transactions data, the average daily traded value remains low relative to trend levels (Figure 2) which implies the CBN’s much advertised FX re-supply is yet to replace the lost volumes from offshore investors. The entire episode harks back to the 2016-17 period when the CBN carried out a similar action and suggests only downhill from here for the parallel market exchange rate. The longer this continues the more humiliating the climbdown could be for the apex bank.

Figure 2: Average Daily Turnover (USD’mn)

Source: FMDQ

A slimmer trade deficit in Q2 2021: CBN trade data shows a 16% y/y moderation in the balance of trade (BOT) deficit to USD4.4billion primarily driven by a recovery in exports (+28% y/y to USD7.9billion) amid a slower rise in imports (+10% y/y to USD11.4billion). Though crude oil prices have rebounded over Q2 2021, the trade data suggests that Nigeria is struggling to ramp-up on spare production capacity possibly due to familiar issues with theft and pipeline disruptions. On the other hand, import demand growth remains firm likely spurred by the easy money policies of the CBN to accommodate a pick-up in growth.  

The week ahead (September 13-17)

In the week ahead, system liquidity is boosted by FGN bond coupon payments (NGN128billion), NTB maturities (NGN162billion) and NGN38billion in OMO maturities. This implies there will be NTB and OMO auctions on Wednesday and Thursday respectively. In terms of event risk, the NBS should release the August 2021 CPI report while the CBN will hold its rescheduled two-day monetary policy retreat on Thursday and Friday.

Declining food prices set the stage for a big drop in inflation:  The NBS is set to release the August 2021 CPI report on Wednesday. Field surveys show marked m/m price declines across which suggests the harvests of key crops are now underway and that the improvement in market supplies are now driving a moderation. In July, rural farm produce prices showed hints of a declining trend and my suspicion is that this picture is likely to have improved over August. Accordingly, my expectation is for a drop in m/m CPI to 0.8-0.85% which spits out a headline print in the range of 16.75-16.81% y/y down from the 17.38% level in July.

NTB will likely move up: The NTB auction on Wednesday should provide confirmation about whether the DMO is trying to resume the convergence game. As the CBN has continued its OMO sales at 10%, there is little to suggest otherwise. At NGN156billion, the amount on offer is sizable and the market will likely look test the 1-yr at a higher level which will only work to heighten bearish sentiments in the market. A lower level will rapidly turn market bullish. There is also the small matter of the delayed Q4 NTB calendar.

September 2021: FX market turmoil provides the argument for monetary policy normalization: Looking across the key macroeconomic indicators, this should be an easy MPC meeting. The economy has just posted the best growth numbers (+5.01% y/y) since Q4 2014 and looks set to easily outperform the gloomy forecasts by the IMF and World Bank. On inflation, a combination of big base effects, and the passage of a ‘normal’ harvest season with no covid-19 linked disruptions should see headline inflation head south over the rest of 2021. Annualized money supply growth using M2 is running at 9% (though M3 is running 1%) which appears in line with CBN’s usual 10% target and a fair balance exists between loan growth in the banking sector and asset quality. Clear skies ahead?

Not quite. In the corner one can see the growing conflagration called the FX crises which will not let up with the Naira plunging to fresh lows at the parallel market. While the CBN’s shift to prohibit sales to BDC operators remains valid, it is yet to follow that move with a normalization in USD supply to the official segments. Without this shift, the current episode of cutting dollar sales to BDCs will merely accelerate Naira weakness at the segment. So, what should be done?  In line with the global theme of normalization announced by the US Federal Reserve and European Central Bank as well as rate hikes by some EM central banks, the CBN needs to start looking to adjust its policy settings back to a semblance of normalcy. This means together with raising actual USD vis Eurobond sales, there needs to be an upward adjustment in interest rates levels and some movement in spot Naira rate. My suspicion is that the CBN will need to move either at this MPC or in November via possible rate hikes (50-150bps) and/or movements in the CRR.

……………………………………………………

“Economists set themselves too easy, too useless a task if in tempestuous seasons they can only tell us that when the storm is past the ocean is flat again – John Maynard Keynes (A Tract on Monetary Reform, 1923)”

In keeping with this quote, I will try to clarify a three-pronged approach I believe could help in fixing the current FX headache.

  • Get dollars: Firstly, the present FX shortage reflects the shock to Nigeria’s current account from the drop in oil receipts over 2020. With rebound in prices over 2021, Nigeria’s external account position should recover over the year which should improve flows to CBN’s FX reserves. Admittedly, this will come with some lag which is where the current confidence game stems from. Markets continue to second-guess if USD33-34billion is enough to equilibrate the FX market at NGN410-412/$ levels. Pending when dollar flows have recovered, the CBN has to ration its dollar sales which leaves the market bifurcated as those with unfulfilled dollar needs bid up the now inadequately supplied parallel market. Fixing this requires a temporary measure (a USD loan) which pushes external reserve levels to a number that allows speculators now start to worry about risk. Presently, it’s a one-way betting street against the Naira with limited downside. Suppose the CBN held USD45-50billion reserves alongside other adjustments (which i set out below) the conversation changes.
  • Raise interest rates: Having raised sizable USD borrowings, the move needs to be complemented by tweaking with Naira interest rates. This is to achieve two objectives. Firstly, the returns for holding Naira (7-13%) pales in comparison to the likely gains from speculation with the parallel market premium at 32%. Am I saying move interest rates to 32%? No. But it’s easy to see that the current one-year return (7%) vis-à-vis inflation at 17% under loose financial market conditions will only generate a steady stream of people willing to take bets on the exchange rate. Raising the rewards to holding naira and tightening liquidity conditions will curb that demand pressure. This position of liquidity management is consistent with the demand management philosophy the CBN regularly pushes on the current account side of things. Secondly, the higher interest rate environment works with attracting foreign portfolio inflows which will deliver another form of support to the FX market. To ensure sustainability and credibility, CBN needs to firmly anchor forward guidance on interest rates to its inflation outlook via s suitable target variable (preferably core inflation). Assuming no shocks to fuel prices, The Nigerian definition of ‘core’ inflation looks set is hovering around 13% levels and the yield on the 1-yr NTB should at least cover this as a target variable.

  • Some flexibility on Naira pricing: By the CBN’s own estimates, the official Naira is over-valued on a PPP basis by around 12% and as such there is reason to expect an adjustment at some point. To ward-off fears about a disorderly breakdown in Naira determination under a fully flexible framework, the CBN should consider a return to the prior policy of having a trading band for the Naira. Essentially, the CBN should initially let the Naira move to the last PPP estimate i.e. NGN466/$ level and create a range around which it trades of say 3-5%. The range can be wider and adjusted as the apex bank deems fit. The Naira can trade freely within this band and CBN interventions should be sufficiently infrequent and unpredictable (vs the predictable weekly auctions under the old WDAS system) and only during periods of extreme volatility caused by global or political events. The CBN should also retain the prospect of changing this mid-point to fit emerging trends in the external account. At the onset the CBN will need to be active in the market and gradually reduce its activity. There is no gainsaying that this will only work if the policy environment is credible i.e. interest rates are set to be consistent with inflationary expectations.

Comments, critiques and clarifications are welcome!

Abbreviations

CBN: Central Bank of Nigeria

CIT: Company Income Tax

DMO: Debt Management Office

FGN: Federal Government of Nigeria

FMDQ: Financial Market Dealers Quotations

OMO: Open Market Operations

PPP: Purchasing Power Parity

NBS: Nigerian Bureau of Statistics

NCB: Non-competitive bids

NTB: Nigerian Treasury Bills

SDR: Special Drawing Rights

VAT: Value Added Tax

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