The third quarter of the year saw bonds bounce back with vigour as the All Bond Index regained some lost ground relative to cash. The index returned a massive 12.57% as yields plummeted nearly 200 basis points on average across the yield curve.

The second quarter ended with a very concerning stagflationary trend firmly in place, and an August and October hike in interest rates priced with virtual certainty. So how did we end the third quarter with the outlook for inflation plummeting and the first cut in interest rates expected by the market in February '09?

Domestically, the announcement that the CPI basket used to calculate the inflation rate was to be re-weighted and rebased to more accurately reflect the spending patterns resulted in a dramatic improvement in the outlook for inflation. The first year-on year measure of the new inflation rate will be for the period to January '09 and will be announced in February '09. The consensus forecast is for inflation to fall by 2-3% as a direct result of the re-weighting. This is a major decline in inflation, which then brings the predicted re-entry of CPIX back into the target band (6%) by as early as Q3 2009 versus the Q2 2010 forecast prior to the reweighting announcement. This development has taken the market completely by surprise, the evidence of which can be seen in July where the ALBI returned 8.5%, which is the single biggest one month return since the emerging market crash in 1998. The market was a little sceptical on the re-weighting announcement given that its timing coincided with inflation spiralling rapidly out of control. It was seen by some as an attempt to stop the rot. However, the focus quickly returned to fundamental inflation drivers as a plunging oil price reduced inflation from petrol prices, and moderating food prices globally began to ease inflation pressure. At the same time, domestic economic momentum continues to slump. The quarter saw further declines in vehicle and retail sales, falling house prices and weakness in consumer and business confidence.

The local bond market has focused on the improved outlook for inflation and the slowing domestic economy. With the R157 now below 9.00% and money market rates above 12.00%, any disappointments on the inflation front could cause yields to move up aggressively. History tells us that in times of slowing global growth, a strong US dollar and falling commodity prices, emerging market assets do not do very well. Our local equity market and the rand seem to reflect this, but the bonds are bucking the trend. Our view is that too much risk premium has been removed from yields due to the positive inflation outlook, and it should be replaced by the emerging market risk premium that normally reflects in assets prices with a global backdrop such as we have now. Any further deterioration in global financing conditions will expose the rand, and thus bond yields will be left in the lurch after pricing in too much good news on the inflation front.

We maintain that the current level of uncertainty from the global credit crisis, and the local inflation outlook warrants caution in portfolios. Given the current uncertainty and global volatility, it is even more imperative that money market portfolios deliver the stability and capital security to investors that they are designed to do.

The RMB Money Market Fund is very conservatively managed, with a very high degree of diversification and uncompromising goal of capital preservation.

Clearly, as a local Rand cash portfolio there is no exposure to any of the global financial institutions that have collapsed. The CISCA rules do allow the fund to invest in deposits with the local branches of international banks, however, we have steered clear of all of these institutions until confidence and certainty re-emerge. We feel comfortable with exposure to local banks, as they have remained insulated from the global crisis to a large degree and have high capital adequacy and low leverage. Returns from cash portfolios remain high, and will continue to do so as we believe rates will remain at these levels for some time. With the fund yield well over 12%, and inflation forecast to fall, real returns from cash look very attractive.

The quarter has seen a fairly dramatic escalation in the stagflation trend, with the inflation outlook deteriorating significantly and economic momentum declining rapidly.

The Monetary authorities came out firing, with 100 basis points in rate hikes, which could have been more if the hawkish rhetoric from Governor Mboweni is anything to go by. The authorities have a major balancing act to achieve, with the upside risk to inflation taking precedence over the downside risk to growth, despite a wide range of criticism, driven principally by the emerging 'left wing' political faction.

The June MPC statement did focus more than usual on the slowing of the domestic economy. We believe the authorities will remain vigilant but are unlikely to be draconian in the pursuit of a quick return to the inflation target range. The continuous rise incommodity prices, along with a prolonged period of significant rises in electricity prices, will result in an inflation profile that exceeds the target range by some margin for an extended period of time. This deterioration in the inflation outlook remains enough to warrant a further 50-100 basis points of rate hikes by year-end, followed by a prolonged period of unchanged interest rates. With the material rise in inflation, real interest rates are actually very low and will need to rise further as inflation expectations increase.

Despite being premature in calling for an end to the hiking cycle, we have kept the portfolio fairly short in the duration of the instruments, given that the risk to our view was always for higher rates. This has enabled the yield to re-price in line with the additional hikes as they occurred.

Given the prolonged period of higher rates expected, we have time before extending the duration of the portfolio. Longer dated yields are offering good value, with the one-year rate close to14%, and we have been investing a portion of the portfolio longer. However, with the current uncertainty around the outlook for interest rates, we will get better yield levels to extend the portfolio's duration.

We managed to make it through the first quarter without further hikes from the Reserve Bank, however, the market is pricing in a 90% chance on another rate hike at the Bank's April MPC meeting. The inflation trajectory has overwhelmed the market with both producer and consumer prices continuing to exceed upside forecasts. The problem for authorities is that this rise in inflation seems to be exhibiting second-round effects related to the exogenous rise in food and oil prices, as well as domestic electricity price increases. It is these second-round effects that may compel the authorities to continue tightening monetary policy, because left unattended it may lead to inflation expectations becoming entrenched at higher levels. The April meeting is a very close call. The risk clearly remains to the upside for rates, with further rand weakness potentially being the catalyst. A hike in April would be justified given the dramatic deterioration in the inflation profile. Thereafter, our view remains for unchanged monetary policy rates for the rest of the year. For this to happen, authorities would need to see inflation stabilising soon, and perhaps even starting to decline, although this will be with the help of very favourable base effects. Under this scenario the authorities would find it very difficult to continue tightening policy with the domestic economy slowing more dramatically now due to the electricity impact on output. Despite this, we have added duration to the portfolio, given that the market is pricing in an April hike. The yield on the portfolio should continue to move higher next quarter.

Upward pressure on interest rates intensified this month with a 50 basis point hike in the repo rate at the December meeting after the MPC adjusted their inflation forecast upwards. The entire money market yield curve rose by 15 basis points, with the 3-month and 12-month interbank rates ending at 11.23% and 11.94% respectively. This brings the cumulative rate hikes to 400 basis points since the start of the cycle in June 2006. The monetary authorities were left with little choice but to increase rates as CPIX breached the official target band of 3% to 6%.

The view on the fund is that inflation will peak in the first half of 2008, and then begin to decline toward the target band in a gradual fashion, sufficiently enough to warrant an end to monetary policy tightening. Where we differ from market consensus is in the fund's belief that it will take some time before the monetary authorities will be able to cut rates. The risk is that more broad-based inflation keeps CPIX above the target band for longer, thus keeping real interest rates fairly weaker and credit and monetary aggregates fairly buoyant, rendering authorities unable to cut rates for most of 2008.

The fund manager is moving the portfolios longer in duration motivated by the belief that the hiking cycle is drawing to a close. With 12-month rates approaching 12%, there is value in extending duration, however, there is no rush as rates will stay high for a while.