Lukanyo Mnyanda talks to economists, watches the selling in the bond market, and wonders who is right

What, you may ask, do investors in the bond market know that our local economists don't?

While economists are bullish on interest rates (the latest Reuters Econometer forecasts a modest 35 basis points rise in the prime rate to 11.85% by year-end), investors have been selling bonds steadily since January.

Bond yields, which move up as the price drops, have risen just over 100 basis points since the beginning of the year, reflecting unease about the prospects for inflation and interest rates going forward.

Although there are other factors contributing to bonds being sold off - such as the increase in the supply of paper due to government's rising finance needs - worries about higher inflation and interest rates in the months ahead are the main driver.

Investors are also looking at developments in the US, where the prospect of higher interest rates is pushing yields higher.

Michael Kwesi Kafe, fixed income strategist at Citigroup, says the yield on the 10-year US Treasury could rise to 5.2% by year-end, from around 4.7% on Friday, which implies an expectation of a substantial rise in rates as the US economy continues to recover.

Emerging market bond yields have also risen significantly this year.

One analyst says the local bond market was already pricing in about 2% in interest rate hikes over the next 12 months, a far cry from the benign outlook indicated by Reuters' survey of economists' views.

Looking at the overall numbers in the Reuters poll can be misleading as it encompasses widely divergent views - from those who expect rates to go up by 150 basis points, to those who foresee no move at all.

But bond investors are still more bearish than economists. The forward rates agreement indicates a belief that rates could rise by as much as 300 basis points by the end of next year. The chances of finding an economist who shares that view are almost non-existent.

Bonds are fixed income products and they benefit from both lower inflation (which raises real returns) and lower interest rates (which improve their competitiveness).

The main factor behind the sell-off in the bond market, analysts say, is the spike in the oil price.

This has led investors to start discounting the possibility of the Reserve Bank getting sufficiently worried about the inflationary effects to start lifting interest rates soon.

In that respect, the Bank's monetary policy committee (MPC) meeting this week, which is not expected to result in a change in policy, will be crucial for expectations.

The Bank's tone, stressing the need not to panic in the wake of rising oil prices, has been calm in recent weeks - which probably explains economists' optimistic views on interest rates.

Statements by deputy governor Ian Plenderleith during last month's monetary policy forum, although indicating that the Bank would act if the need arose, were seen to underplay the likelihood of a panic reaction to what could be a temporary spike in oil prices.

The tone could change when the MPC releases its statement on Thursday; it could instead stress the danger of sustained higher oil prices feeding through into higher inflation.

Movements in the bond market have probably been pricing in an increased risk of this happening, while econo mists are probably looking at fundamentals, which suggest that oil prices should ease over time.

But there is widespread scepticism that Opec's decision to boost production - which saw prices dip below 40 on Friday - will have a meaningful effect, considering that its members have been busting their production quotas anyway.

There are rising fears that Saudi Arabia could become increasingly unstable with each al-Qaeda-linked attack. T his, with demand from China and speculation in financial markets, is driving oil prices higher.

The relative strength of the local economy - evidenced by still-buoyant consumer spending and a recovering manufacturing sector - could also give the Bank space to move if it felt so inclined, says Citigroup's Kafe.

Heather Jackson, head of fixed interest at African Harvest Fund Managers, says strong demand is making it easier for retailers to pass on increases to consumers. The bond market seems to think that this, together with higher oil prices, has increased the risk of rates going higher sooner rather than later.