US Fed hike means more pain for Naira assets

…Nigerian Bonds and stocks have sold off this year. There may be more pain ahead!

For most of 2011 while most emerging markets (EM) such as Brazil and South Africa were dealing with excess portfolio inflows which were pushing up the value of their currencies (the Real and Rand) the Central Bank of Nigeria (CBN) had to draw heavily on dollar reserves to defend the currency (Naira) and avoid depreciation.

As the CBN struggled to sustain stability in the domestic foreign exchange market it moved its target trading band for the naira to N155 naira +/-3 percent, from N150 naira +/-3 percent.

The bank also began the gradual process of jerking up its monetary policy rate (MPR) to an elevated 12 percent and removed the minimum one year hold period for Government bonds by foreign investors.

This culminated in the October 1, 2012 addition of Nigerian bonds to JP Morgan’s emerging market index (GBI-EM), leading to an estimated $1.5 billion of inflows as offshore investors engaged in the carry trade, borrowing dollars in the low interest rate environment of the west, to invest in naira denominated assets.

The party for carry traders in naira assets came to an abrupt halt in 2015 as falling oil prices and misguided/unorthodox CBN policies led to Nigeria being kicked out of the JPMorgan bond index.

In 2016 Nigerian stocks and bonds have sold off as foreign investors stayed away from the Nigerian Stock Exchange (NSE) and yields rose on fixed income securities to compensate for the country’s elevated risk premium and deteriorating balance sheet.

Last week’s rate hike by the U.S Federal Reserve threatens to exacerbate these trends as investors sour on EM assets and oil/commodity prices retreat as the dollar strengthens.

The Fed lifted its target for overnight borrowing costs by 25 basis points, or 0.25 percentage point, on Wednesday to a range of 0.5 percent to 0.75 percent.

On Friday the dollar jumped 1.2 percent to $1.0415 per euro, reaching its strongest level since January 2003. The greenback advanced as much as 1.4 percent against the yen.

Gold futures sank 2.9 percent to $1,129.80 an ounce, after touching their lowest level since February. Futures have slumped 15 percent since the end of September. Meanwhile West Texas Intermediate crude slipped 0.3 percent to $50.90 a barrel.

Some analysts think the dollar strength is just beginning which would be bearish for Nigerian assets largely through commodity price pass through.

Deutsche Bank AG Strategist George Saravelos says the Federal Reserve’s first interest rate hike in a year marked the start of a new regime for the U.S. dollar.

“Historically, it is not only the direction of U.S. yields that matters for the dollar but also the absolute level,” Saravelos wrote in a note to clients on Friday. “When the USD joins the ranks of the high-yielders – defined as having at least the third highest central bank yield in the G-10 – it typically rallies very strongly.”

Wednesday’s rate hike propelled the effective federal funds rate to 66 basis points, moving it above the Bank of Canada’s overnight rate for the first time since 2007, and leaving New Zealand and Australia as only two G-10 currencies whose central bank policy rates are above the U.S., according to data from Bloomberg.

A stronger dollar often equates to weaker commodity prices as they have an inverse relationship.

This will be particularly negative for Nigeria which depends on oil prices for some 90 percent of its export earnings.

Nigerian stocks have already lost 6.7 percent this year while bond yields are rising.

Investors were demanding yields of up to 18 percent in a bond auction last week as the country raised only N69.2 billion ($227 mln) in bonds maturing in five, 10 and 20 years’ time, less than the N95 billion naira it had wanted.

The Debt Management Office (DMO) eventually paid 16.43 percent to auction N41 billion, maturing in 2036 and fetched N25 billion due in 2026 at 16.24 percent. It issued N3.2 billion of 2021 at 15.99 percent. It paid around 15 percent for these notes at its previous auction last month.

The CBN believes that the prospects of investors earning positive real rates of return is an incentive to own naira denominated assets hence its hike in interest rates in recent months.

The CBNs conundrum however is that as with most emerging markets central banks what affects monetary policy is largely outside its controls.

For Nigeria these include the price of oil in the international markets, the global growth environment and the outlook for the U.S Fed funds rate.

With Nigeria’s oil price benchmark for its 2017 budget pegged at $42.5 investor confidence in the CBNs ability to defend the defacto dollar peg of N305/$ will continue to erode if oil prices stay lower for longer.

A combination of benign global growth, lower oil prices, widening current account deficits, and higher borrowing costs to fund the FG deficit, would put further pressure on the Central Bank’s ability to conduct monetary policy for which the naira is the nominal anchor.

What this means for Nigeria is another year of low to zero real growth and falling asset prices if the CBN doubles down on current policies in response to the coming turbulence from a strong dollar.

 

PATRICK ATUANYA