Johannesburg - Bond prices surged yesterday, driving yields to record lows, after an index of producer inflation fell to its lowest in three decades.

By 5pm the yield on the R150 had strengthened 40 basis points on the day to 8.9 percent, the biggest one-day rally since January 7 2001. The R153 strengthened 21 basis points to 8.91 percent.

The producer price index slowed to 1.1 percent in May, the lowest rate of increase since at least 1971, and down from 3.3 percent in April, Statistics SA said.

That compares with the 2.6 percent average forecast of nine economists surveyed by Bloomberg News. Slowing factory gate inflation bolsters the case for more interest rate cuts this year.

Natheem Alexander, who helps manage bonds and cash at Abvest Associates, said: "It is definitely good in terms of inflation expectations."

"It seals the case" for a rate cut in August.

Alexander recommended buying debt maturing in seven years or less, which stands to gain most as short-term interest rates fall. Lower interest rates boost the returns on bonds relative to cash.

Reserve Bank governor Tito Mboweni said on Tuesday that the average inflation rate next year would probably be in the middle of the bank's target range of 3 percent to 6 percent.
This has fuelled speculation the bank is set to cut the repo rate again at its next policy committee meeting in August.

Chris Hart, a senior economist at Absa Group, the country's biggest mortgage lender, said: "There is still considerable scope for the consumer price index and CPIX to fall significantly."

CPIX is consumer price inflation less mortgage costs.

The producer price index numbers would "provide the Reserve Bank with greater confidence to lower rates at a more aggressive pace", Hart said  
.

Absa expected the Reserve Bank to cut interest rates by 3 percentage points over the next eight months.

The yield on the two-year R150 bond dropped below the yield of the seven-year R153 for the first time since August as the shorter-dated bond's yield fell faster in anticipation of interest rate cuts.

The interest rate on a three-month forward rate agreement starting after the August monetary policy committee meeting fell 20 basis points to 10.29 percent, or 1.3 percentage points below the three-month Johannesburg interbank agreed rate.

That indicates many investors expect a rate cut of more than 1 percentage point in August.

The rand gained for a second day against the dollar after Mboweni said he wanted a strong currency to help keep inflation in check.

The rand rallied to a best level of R7.676 against the dollar. In late trade it was 9.63c stronger on the day at R7.6913 against the dollar, bringing its gains in the past two days to 2.7 percent.

Alex Patelis, a strategist at Merrill Lynch in London, said in a report the rand was still significantly undervalued against the dollar compared with the Australian dollar, another currency dependent on commodity exports.

The rand might climb to as high as R6.50 against the dollar as interest rates higher than in the US and Europe attracted foreign investment to the country's bonds, he said.

Sapa-AFP reports from London that the euro made slight headway against the dollar yesterday amid signs of improvement in the German economy, although traders were focused firmly on an anticipated cut to US interest rates last night.

The single European currency was trading at $1.1524 from $1.1508 late on Tuesday in New York. The dollar was at ´117.68 against ´117.89 on Tuesday.