Egypt’s Upside-Down Bond Market Vindicates Shock Devaluation

CAIRO (Capital Markets in Africa) – A bond-market quirk is vindicating Egypt’s decision to undertake the world’s biggest currency devaluation in at least two years.

The yield on the government’s shortest-maturity treasury bills is higher than the rate on its longest debt for the first time since Bloomberg started tracking the market in 2006. That so-called yield inversion is a welcome signal because it points to slower inflation and lower interest rates in the future, according to Brown Brothers Harriman & Company. Normally, longer-maturity debt pays a higher yield to compensate investors for climbing prices.

Egypt’s shock switch to a free-floating exchange rate at the start of November erased almost half the pound’s value as the government sought to quash a rampant black market and bolster reserves by winning an International Monetary Fund loan. One month later, with international capital returning and the government’s foreign-currency cash pile at a five-year high, the yield-curve anomaly reflects investor bets for a stronger pound and slower inflation as the impact of the devaluation fades.

“The inversion suggests to me that the central bank has, for now, succeeded in keeping inflation expectations under control,” said Win Thin, the head of emerging markets at Brown Brothers Harriman in New York. “Once the central bank feels that inflation has been squeezed out, it will cut rates. So the curve should move from inverted to positively sloped as the bank cuts.”

The government sold three-month treasury bills this week at an average yield of 18.2 percent compared with a rate of 16.7 percent for 10-year bonds. In the currency market, one-month Egyptian pound forwards traded at 17.8 per dollar on Tuesday, 0.1 percent stronger than the spot exchange rate. Those contracts were showing a discount of as much as 20 percent to the official rate on the eve of the pound’s devaluation, data compiled by Bloomberg show.

“The market fully believes that Egyptian assets, and especially the currency, will appreciate in the future,” said Bryan Carter, who helps manage about $1.3 billion as head of emerging-markets fixed income at BNP Paribas Investment Partners in London. “After a currency floats and devalues sharply there is a period of overshoot when it trades too cheap and then investors come back to re-establish fair value.”