Economy Today’s inflation report in Indonesia will suggest that further rate hikes from Bank Indonesia are likely - DBS Vickers

Today’s inflation report in Indonesia will suggest that further rate hikes from Bank Indonesia are likely. The annual headline inflation rate is expected to have fallen to 5.94% in May from 6.16% in April, but core inflation should have risen to 4.7% last month from 4.62% the month before. The trend in core inflation still suggests that further rate hikes from Bank Indonesia are still in order later this year. Essentially, even if the annual headline inflation rate is stabilizing, the risk of a broadening of price pressures amid strong growth remains. Against this outlook, government bonds remain expensive, but inflation trends matter little to the bond market at the moment.

They simply don’t have the capacity to cheapen bonds, as in theory they should. The outlook for yields depends more on the direction of capital flows than determinants of fair value, like inflation and fiscal deficits. Because portfolio flows are large relative to the size of the market, the entire net supply of government bonds continues to be taken up by foreign entities and there is a shortage of government bonds overall. That’s why even higher oil prices in 1H11 and their negative impact on inflation measures and the government’s fiscal position had no impact on yields.

This has been the case for a while now and could go on, but the fact remains that yields are low and the curve flat because of foreign demand not fundamental factors. Therefore, we remain wary of short periods of capital outflows or higher USD yields triggering a bearish resteepening of the Indonesian local currency government bond yield curve.