Government bond yields are influenced by many economic drivers but none more than the inflation rate and fiscal outlook. The reason for this is simple 1) lower inflation implies higher real returns on fixed rate bonds, and; 2) lower inflation allows for a lower repo rate which makes bonds more attractive. The fiscal outlook is important because a budget deficit (surplus) implies that government will need to increase (decrease) its borrowing (increase/decrease supply of bonds) which drives down (up) the price of bonds (yields rise/fall). It is not unusual for these two drivers to move in a different direction. After all inflation usually falls due to slower economic growth which often requires increased government expenditure (and a wider fiscal deficit).

So, under normal economic conditions, the cyclical change in the budget deficit is not considered to be a long-term risk for bonds because it is seen as a tool for smoothing the economic cycle. In basic economic terms government increases expenditure, the fiscal multiplier kicks in and the private sector recovers. This in turn pushes up tax revenues and allows for a relatively stable stock of debt.

The “text book” description of the inflation/fiscal/bond yields relationship fitted well to the South African experience from 1994 until 2008 and was the basis for our optimistic stance in previous notes where we discussed the fiscal dynamics. The point we made was that the current debt levels are not unprecedented and that South Africa managed to bring the level of debt to GDP down from above 49% in 1995 to 26% in 2008

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