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Yield Economics – Markets – Strategy With 10Y IDR yields in the 12-13% range, we think government bonds are a buy Indonesia: Sell-off is over With the Indonesian government having raised the price of subsidised fuel by an average 28.7% in May, market attention is now fixated on the question of whether this is enough to save the budget from collapsing under the weight of growing subsidy bills. We reckon it is not, if the price of oil averages more than $115/barrel in 2H08 (see economics section for details). Bond investors seem to be sceptical too, judging by the fact that 10Y yields have entered the 12-13% range, within which the policy rate peaked in 2006, when the government lifted fuel prices by 126% (Charts 21 & 22). Now, after the sell-off, there is value at current levels. We don’t expect yields to rise much above current levels, even if international oil prices rise further and the Indonesian government is forced to adjust subsidies a second time. Hence, we think long-end Indonesian Government bonds are a buy. We expect yields to fall in 2H08 and the curve to steepen, as policy rates are unlikely to rise to 13% again. We currently think that Bank Indonesia will lift rates to only 9.25% in the coming months and hold at that rate well into 2009. That said, as the currency outlook is deteriorating with Fed rate hikes likely in 4Q08 and 2009 (see currency section for details), we think that there is the risk that Indonesian government bonds fail to rally and actually come under fresh upward pressure. Chart 21: 10Y IDgov Yield vs Policy Rate %pa Chart 22: 2Y IDgov, 10Y IDgov & Spread %pa 14 bps 400 15 13 12 2/10 Spread (RHS) 2Y IDgov Yield 10Y IDgov Yield 350 300 250 11 10 200 9 7 10Y IDgov Yield 1M SBI 5 Aug-05 Feb-06 Aug-06 Feb-07 Aug-07 Feb-08 8 6 Nov-06 Feb-07May-07Aug-07Nov-07 Feb-08May-08 150 100 50 0 The Philippines: Rate hikes on the horizon Bangko Sentral ng Pilipinas on June 5 lifted its policy rates by 25bps, citing indications that supply-driven inflationary pressures are beginning to feed into demand. Policy makers are seeing early evidence of second-round effects and the need to act promptly to rein in inflationary expectations. Headline CPI inflation in May was up 9.6%YoY, continuing to threaten the BSP’s inflation targets for 2008 and 2009, which stand at 7.0-9.0% and 4.0-6.0%, respectively. Rate hike concerns are justified given that headline CPI inflation has risen to 8.3%YoY in April, but we don’t think an aggressive tightening cycle lies ahead (Chart 23). Real GDP has slowed sharply in 1Q08 to 5.2%YoY from 6.4%YoY in 4Q07 as the economy expanded at only 0.8%QoQ sa in 1Q08. That is among the slowest since 2001. 50
Economics – Markets – Strategy Yield Chart 23: 2Y PHP yield vs Headline CPI Inflation %pa, %YoY 20 18 16 14 12 10 8 6 4 2 CPI 2Y PHgov yield 0 Jan-99 Jan-02 Jan-05 Jan-08 Chart 24: 2Y PHgov & 10Y PHgov - 3M Phibor 10Y Phgov - 3M Phibor (bps) 800 700 600 500 400 300 200 100 0 y = 1.4127x + 113.58 Last 800 trading days 2Y/10Y curve tends to steepen when 2Y rises above 3M Phibor -100 -200 -200 0 200 400 600 800 2Y Phgov - 3M Phibor (bps) Moreover, while liquidity conditions remain ample, excess reserves continue to be placed with the BSP, suggesting that there is little risk of overly aggressive and inflationary bank lending. As the central bank reported in its 1Q08 inflation report, SDA placements stood at P591 billion in Mar08, up from last year’s level of P53 billion and total volume of banks’ placements with the BSP under the RRP window stood at P248 billion in Mar08, down from last year’s level of 307.8, but still high compared to levels prior to 2005 (Chart 25).The more than tenfold increase in SDAs followed the policy measures implemented by the BSP in May last year to rein in strong liquidity growth. Then, trust entities of BSP-supervised financial institutions were allowed to make placements in the SDA facility. Given slowing growth, the fact that inflation is mainly due to cost pressures and that it is unlikely that there will be inflationary bank lending, we think the BSP will not hike rates aggressively. We expect another three rates hikes of 25bps at the three coming policy meetings. This is bad news for the bond market and means yields will remain under upward pressure. A sharp rise from current levels is, however unlikely, given that the bulk of the sell-off in the bond market has already occurred (Chart 26). The 2Y/ 10Y curve looks flat given the new yield levels, suggesting that steepening is probably more likely than flattening, unless yields fall sharply relative to money market rates (Chart 24). Policy rates are likely to rise further in the Philippines as the central bank reins in inflationary expectations Chart 25: Outstanding RRPs PHP bn 350 300 250 200 150 100 50 0 Jan-00 Jan-03 Jan-06 Chart 26: O/N Repo & Rev. Repo vs 2Y & 10Y %pa 16 14 12 10 8 6 O/N Reverse Repo O/N Repo 2Y PHgov 10Y PHgov 4 May-05 May-06 May-07 May-08 51
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