Rand’s fortunes rely on SA interest rates moving in lockstep with the US
Foreign exchange responses to a central bank-filled week highlight their sensitivity to the interest rate differentials that are expected to prevail during the second half of the year. As always, the rand is particularly prone to these dynamics — making its fortunes dependent on the SA Reserve Bank following in the Fed’s footsteps.
It has been an action-packed, central bank-filled few weeks that have highlighted how important it will be for the SA Reserve Bank (Sarb) to keep up with the US Fed on the interest rate front — or fall prey to the risk-off bouts of investor sentiment that are likely to predominate through the second half of this year.
The Sarb made a good start of it last week when it upped the ante by hiking the SA repo rate by 50 basis points (bps). This, with indications that the European Central Bank may begin raising rates, allowed the euro to rally against the dollar and saw the rand win back some ground against the greenback.
Izak Odendaal, an investment strategist at Old Mutual Multi-Managers, calls the Sarb rate decision a “Fed-dependent” hike, saying the decisions could not be considered data-dependent. The local inflation outlook had not deteriorated so dramatically that a 50bp hike (as opposed to a 25bp increase) was necessary, he explains.
Last week’s decision to move in lockstep with the Fed, says Odendaal, shows that: “As long as the Fed is hiking aggressively, the Sarb will feel under pressure to do the same.”
The rand’s sensitivity to the Fed was again evident this week in the wake of the release of the US Federal Reserve’s latest monetary policy meeting minutes, which essentially reiterated the central bank’s unwavering commitment to making at least another two 50bp rate increases at its next two meetings and to bring inflation back from its more than 40-year highs to around its average 2% inflation target.
Oxford Economics’ chief US financial economist, Kathy Bostjancic, describes Fed officials as “highly attentive to inflation risks” and ongoing supply chain disruptions.
“Similar to our view, the Fed sees an easing of supply chain bottlenecks and a further rebound in labour force participation as helping to reduce supply-demand imbalances and dampen inflation.”
She says the minutes underscore the fact that the Fed needs to continue with its 50bp rate hikes at the next few meetings, but that the prevailing view is that: “Expediting the removal of policy accommodation would leave the committee well-positioned later this year to assess the effects of policy firming and the extent to which economic developments warranted policy adjustments.”
Also significant was that the committee was pleased that its forward guidance had been helpful in shifting market expectations to align more closely with their assessment of monetary conditions and had contributed to the tightening of financial conditions.
She says the minutes support her revised forecast for 250bps in rate hikes this year, “lifting the midpoint of the fed fund’s target range to 2.63% by year-end”.
The Fed’s aggressive anti-inflation stance will be a hard act for the Sarb to follow, given the various headwinds facing the domestic economy, namely, Eskom load shedding, the KZN floods and a global backdrop in which a recession or stagflation is not yet out of the question.
But Odendaal says the Sarb decision shows it intends to front-load its interest rate hikes, and thus another 50bps hike is possible in July. Thereafter, however, the central bank is likely to switch back to “data dependence”.
To date, SA has increased interest rates by more than the US, with the repo rate hike of 125bp higher during this cycle versus the US’s 75bp. Investec economist Annabel Bishop says the erosion of the differential between US and SA interest rates has a notable impact on the domestic currency.
Looking forward, however, she points out: “While SA’s interest rate hikes to date exceed those of the US, it does not have an MPC [Monetary Policy Committee] meeting in June, and the FOMC [Federal Open Market Committee] does, where another 50bp hike is widely expected, which will then see the US and SA interest rate hikes equate, increasing the risk for greater rand weakness.”
As a result, she also believes that SA needs to match US rate hikes to avoid rand weakness and the pressure this would put on domestic inflation outcomes. Historically, the impact on the domestic currency has been “very severe” when SA has been out of line with the US rate hike tightening cycle, adds Bishop.
South Africa also has some way to go before it catches up with the significant rate increases in other emerging markets. But Odendaal notes that commodity prices and global risk appetite “will continue to matter greatly” in the rand’s fortunes.
Absa recently indicated that it believes the rand is currently undervalued, given that the current account is set to remain in surplus this year. The economic unit expects the rand to recover to R15.25 to the dollar by mid-year — still above its R14 to R15 range most of this year and before the sharp depreciation that set in during mid-April, taking the currency above R16 to the dollar.
On a positive note, Lazard Asset Management, in its analysis of emerging markets, felt that the Sarb decision to step up its pace of monetary policy tightening means that there continued to be value in both external and local debt in SA and it expects “a slower pace of rate hikes going forward as inflation cools and the output gap remains wide”.
That’s encouraging in an environment in which, as the investment bank points out, risk assets have been punished and emerging market debt as a whole is on track to experience its worst calendar year on record — including the global financial crisis and during the taper tantrum in 2013.
While Lazard may be generally optimistic about emerging markets’ hard currency debt at these levels, the perfect storm of events that led to these dire results remains in place and ongoing volatility is assured. Within this context, the pressure on the Sarb to keep up with the Fed so that it can reduce inflation while maintaining the rand’s strength is likely to be intense for some time to come. DM/BM