Rand Continues to Reap What Fed has Sewn but Domestic Politics Mean Volatility Will Return

Image © Government of South Africa

- ZAR extends Federal Reserve-induced gains but volatility will return.

- Investec warns of populist rhetoric ahead of election and rating threat.

- Odds of rating downgrade are finely balanced and key to Rand outlook.

The Rand scored more gains over rivals Thursday as the South African currency continued to benefit from a U.S. Federal Reserve (Fed) that's becoming more conscientious about the economic impact of its monetary policy, but the current honeymoon might not last for long.

Federal Reserve policymakers signalled strongly in December that they will be more cautious about raising interest rates this year, prompting financial markets to offer the Dollar lower and begin speculating it won't raise rates at all in 2019.

This has been music to the ears of South Africa's Rand, which was hurt by a multitude of factors last year although most significantly by Fed policy and its impact on the emerging world.

Some say markets should not have taken the Fed's December guidance to heart as the bank could be forced to raise rates again this year. One such group is the currency research team at HSBC.

"The market is now flirting with the possibility of an interest rate cut by the Fed during 2019, apparently confident that the tightening cycle is over. However, with the broad swathe of US data still consistent with above-trend growth alongside a tight labor market with accelerating wage growth, a data-dependent Fed may yet be tempted to deliver higher rates," says Tom Nash, a strategist at HSBC.

However, and even if Fed does in fact abandon its earlier push to take U.S. interest rates all the way up to the so-called "neutral" level, there are plenty of reasons to avoid banking on the Rand's newfound strength enduring.

Econonists at Investec Bank have flagged a series of domestic events that they say will likely lead to renewed volatility in Rand exchange rates over the coming months. This means there are big down as well as up days ahead for the Rand.

"The start of 2019 has seen risk-aversion abate somewhat in global markets as commentary from US monetary authorities has become less hawkish," says Annabel Bishop, chief economist at Investec. "Risks for SA abound, ranging from fiscal performance, and particularly the threat of credit rating downgrades, to the upcoming national election."

South Africa's general election, which is expected to be held in the first half of 2019, will mean "populist" rhetoric and political uncertainty increases over the coming months according to Bishop.

In light of the 2018 recession, elevated interest rates and given rising levels of inflation that have hurt household finances, government spending will be a key issue at play in the election. So too may a controversial programme to expropriate land from citizens without compensation.

And given the ongoing threat to South Africa's credit rating, markets may respond to any rhetoric suggesting budgets and spending might increase after the ballot simply by dumping the Rand before the election takes place.

Above: USD/ZAR rate shown at daily intervals.

The USD/ZAR rate was quoted 0.23% lower at 13.83 Thursday and has fallen -3.32% so far this year, after a Rand-punishing double-digit increase back in 2018. The Pound-to-Rand rate was -0.20% lower at 17.69 and has declined -3.14% in 2019.

Above: Pound-to-Rand rate shown at daily intervals.

"A downgrade from Moody’s would place substantial upwards pressure on SA’s interest rates, the SARB has estimated around 100bp higher in the short-end of the yield curve, and so certainly place upwards pressure on the repo rate," says Bishop.

South African Finance Minister Tito Mboweni unveilled in October a 2019 spending plan that puts the budget deficit at 4% for 2018 and 4.2% in 2019, before the mismatch between government income and spending stabilises at 4% in subsequent years.

That is a significant deterioration from the projections reported back in February when the government said its budget deficit would fall from a 4.3% in 2017, to 3.6% in 2018 and that it would stabilisie at 3.5% in 2020.

Moody's, the last main agency to still rate long-term South African debt as investment grade, will review its rating in March less than a month after the next government budget that is expected to be delivered in February.

"SA could find it difficult to avoid an interest rate hike in the face of the substantial rand weakness such a meaningful credit rating downgrade would engender, and we currently see at least a 47% likelihood of this occurring," warns Bishop.

Changes in interest rates are normally only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

The South African Reserve Bank (SARB) might be forced to hike its own rate in an aggressive manner if there is a downgrade to the credit rating, in order to prop up the currency, because losses for the Rand could send inflation surging higher if they are steep enough.

The Rand would fall after a downgrade, which would send a negative message to South Africa's creditors about their prospects of repayment, because without a top-knotch rating many of the world's biggest fund managers would be forced to jettison the government's bonds from their portolios.

That would inevitably lead to selling of the currency.

Bishop and the Investec team say their "base case" is a downgrade will be avoided and the SARB raises its interest rate only once in 2019, to 7%, which should force the USD/ZAR rate down to what will then be an 18-month low of 13.05.

However, the likelihood of this scenario playing out is just 42%, Bishop says, and the chance of Investec's "down case" playing out is not far behind at 37%. Those are finely balanced odds.

The down case would see the SARB raise its interest rate from 6.75% to 8.5%, crushing the economy in process, and the USD/ZAR rate still rising all the way up to 18.50.