Macro-fiscal analysis
Working paper

The information content of the yield spread about future inflation in South Africa

by Manqoba Ntshakala and Laurence Harris
June 2018

1 Introduction

The ability to predict future economic conditions, such as business cycle variables and an inflation measure, using presently available information is valuable for firms, households, and policy makers. In particular, a forward-looking inflation-targeting regime such as that the South African Reserve Bank (SARB) formally adopted in 2000 requires systematically unbiased estimators of expected inflation for Monetary Policy Committee interest rate decisions. In principle, the yield spread—the spread between market yields on short- and long-term government debt—contains information on expectations of future inflation that can be extracted as an estimate of them. The tests reported in this study support the notion that the yield curve does, in fact, contain useful information for inflation-targeting monetary policy in South Africa.

The relationship at any observation date between the market yields of fixed-interest government securities of differing terms to maturity can be represented by a yield curve. Because the instruments are multi-period assets (liabilities) and their yields relate future income streams to the present, the level, slope, and shape of the yield curve reflect rational agents’ market views of future economic conditions. Studies of US and other markets have demonstrated that the yield curve does contain information on expected and actual future levels of gross domestic product (GDP) growth, and can be a lead indicator of business cycle downturns (Estrella and Mishkin 1998; Rudebusch and Williams 2009). Others have demonstrated that it contains information on expected and actual future inflation (inter alia, Kotlán 1999; Kozicki 1997; Mishkin 1989). The summary measure of yield curve slope used in existing research is a measure of the yield spread, the difference between yields on longer- and shorter-dated debt securities.

Although many studies indicate the inflation-predicting power of the yield curve in developed countries’ markets, little is known of the relationship in emerging economies. The relatively underdeveloped nature of many such economies’ fixed-income markets may account for that, but studies of South Africa’s yield curve in its highly developed capital market are not subject to such limitations. South African government bonds with nominal value totalling more than R1 trillion and a dense range of maturities are listed on the Johannesburg Stock Exchange, together with a large volume of corporate and other debt. With nearly R25 billion traded daily, the government bond market, supported by the market-making role of appointed primary dealers and a developed ecosystem including markets in derivative products, has high liquidity. This study contributes to the existing body of knowledge within the South African context by empirically examining the ability of the yield spread to provide information about future inflation. Additionally, we examine the effect of the monetary policy regime shift associated with the adoption of inflation targeting on the relationship between the yield spread and future inflation.

This paper is structured as follows: Section 2 reviews the key relevant research literature. Section 3 describes the methodology employed in this paper and the derivation of our model to be estimated. Section 4 details the data used, the empirical results, and interpretation of the findings; Section 5 concludes.