First published in the Daily Maverick 168 weekly newspaper.

How quickly the tide has turned, with the currency having given up almost all its gains in a matter of days.

What could have changed? And where will it go from here?

Once again, investors should rather look at dynamics affecting the US dollar, because, as is usually the case, the fate of the rand may be more contingent on external factors than on that of the domestic South African context.

The question should perhaps rather be: do the past two weeks mark the end of the most over-bought trade in markets thus far in 2021; selling the greenback?

To answer this question, it is worth interrogating the two main narratives behind why the dollar has been so weak.

The first is economic fundamentals. Currency weakness must, when short-term market volatility is stripped out, eventually be a function of an economy running persistent twin deficits: current account and budget.

Like other countries, the US buys more from the rest of the world than it sells and has to find a way to finance the difference in its current account. Usually, this is in the form of investment coming into the US, seeking safe haven in the treasury market or exposure to the equity market.

If, however, appetite wanes for US treasuries or the stock market then the currency must function as an adjustment mechanism and weaken, effectively putting US assets on a cut-price “sale” for the rest of the world. The US current account deficit is at a near 15-year high of almost 3.5% of GDP, which needs to be funded by selling ever weaker dollars.

The second deficit is the amount of treasuries that are being sold to cover the US government budget. If supply of treasuries continues to rise, investors will, at some point, demand higher interest rates to buy them. Demand at the same price cannot go on forever.

As we have seen over the past 18 months, however, demand for treasuries is skewed by the $80-billion a month that the Fed spends on effectively putting a lid on yields.

Despite all the talk of looming inflation and a higher-than-expected June US CPI print of 3.6%, the US 10-year yield is around 40 basis points lower since its highs in late March (yields move inversely to prices), to where it currently trades at around 1.4%.

So, if the twin deficits are not shrinking, and if yields won’t adjust upwards to attract investors, then what is the one factor that can take up the slack? The exchange rate!

Effectively, when you have these material and persisting imbalances, the USD has to get “devalued” but only when the “safe haven” of its global reserve currency status – its “exorbitant privilege”, as described by former French president Valery Giscard d’Estaing – holds less appeal.

That takes us to the second, market-driven narrative – the “dollar smile” that foreign currency traders often refer to.

When the US is growing and corporate earnings are growing faster than those in the rest of the world, investment is sucked into the US and the dollar strengthens. That is the one side of the “smile”. Similarly, if the US and the global economy is seemingly peering over the side of a cliff, investors seek shelter, driving up the value of the greenback.

In the past two weeks, however, the narrative on the US economy has clearly changed, from one of a Goldilocks situation – not too hot and not too cold, with the dollar languishing in the middle of the smile – to the Fed starting to talk up a rate rise in 2023.

Suddenly, capital sitting uneasily in economies such as South Africa can start to plot a return to a real yield in the greenback, hence its recent strengthening.

As for the future direction of travel, as ever, investors should keep a close eye on the US 10-year yield. Should the US economic rebound look like it is gaining pace, with yields rising, higher inflation and further interest rate hikes on the cards sooner rather than later, expect the current trend to continue as investors position themselves for a fast-growing US economy by buying dollars.

If the US and global post-pandemic recovery seems to be running out of steam by the end of 2021, with yields going lower than they are now, expect investors to look for shelter from economic uncertainty in the safe haven of the reserve currency.

Back to business as usual, then. DM168

Natale Labia is a partner at Lionhead Capital Partners.

This story first appeared in our weekly Daily Maverick 168 newspaper which is available for free to Pick n Pay Smart Shoppers at these Pick n Pay stores.