Although the rand briefly weakened on the back of the surprise interest rate cut last week, it does not mean the currency will persistently weaken, say Dave Mohr and Izak Odendaal, investment strategists at Old Mutual Multi-Managers.
In a company note issued on Monday, Mohr and Odendaal say the relationship between interest rates and exchange rates is not nearly as “mechanical” as is often assumed.
“Rather, commodity prices, perceptions of global monetary policy and sentiment towards emerging markets will determine the outlook for the rand over the medium term, and if favourable, the currency could even continue strengthening despite possible further rate cuts.”
On Thursday July 20, the South African Reserve Bank (SARB) lowered interest rates with a 25 basis points, which means that the repo rate, the rate at which the SARB lends money to commercial banks, is reduced from 7.00% to 6.75% and the prime lending rate changes to 10.25%.
The rand briefly lost some ground, moving to R13.00/$ immediately after the rate cut announcement. The currency opened trading on Thursday morning at R12.91/$.
Mohr and Odendaal sketch the global and local environment against which the surprise rate cut took place.
“The global backdrop to last week’s Monetary Policy Meeting (MPC) is one of fairly robust economic growth and stubbornly low inflation.”
Mohr and Odendaal point out that Chinese growth increased to 6.9% in the second quarter, showing resilience despite the government’s efforts to clamp down on excessive credit. “While these numbers are often viewed as suspiciously smooth by some, other credible data, such as exports and imports, also show robust growth.
“This combination of robust growth and low inflation is creating some confusion in central banking circles, as one would normally expect stronger growth to push up inflation as the economy runs out of resources. Last week, for example, the Bank of Japan had to delay the window for achieving its 2% inflation target for the sixth time to 2019, despite unemployment at a 20-year low of 2.8%.
The divergence between growth and inflation is also causing uncertainty in terms of market expectations of central bank actions, particularly the European Central Bank (ECB) and the US Federal Reserve (Fed).
The ECB left rates unchanged last week and also did not change its guidance in terms of how it expects policy to evolve over time. Its policy interest rate is expected to remain negative well into 2018, but despite this and large-scale quantitative easing, core inflation is only 1.2%.
“Meanwhile, the Fed is on a stated course to continue gradually hiking interest rates and eventually reduce the size of its balance sheet. But how gradually it does this is the issue. The Fed is expected to hike rates three times this year but has consistently overestimated its own hiking cycle.”
The Fed is expected to leave interest rates unchanged this week, while the market is now only pricing in a 40% probability of a third rate increase this year, as inflation remains stubbornly low.
While this combination of stronger global growth and below target inflation may create headaches for central bankers, it is generally seen as a benign backdrop for financial markets, according to Mohr and Odendaal.
The rand has been volatile over the past two months, exposed to shifts in perceptions of global central bank policy and local political developments. A debate on the independence of the SARB and the appropriateness of its inflation targeting mandate has flared up causing movements in the currency.
“However, the rand gained against US dollar since the previous MPC meeting in May, while the dollar itself is weaker against major currencies,” Mohr and Odendaal say.
June consumer inflation declined to 5.1%, while core inflation, excluding volatile food and energy prices, was steady at 4.8%.
The MPC sets interest rates to influence the trajectory of future inflation (one to two years out), since rates changes take time to impact the economy. The updated inflation forecast is therefore important.
Inflation is expected to average 5.3% this year, down from 5.7%, while forecasts for 2018 and 2019 were also cut. After the unexpected decline in GDP the first quarter, the growth outlook for the year has been halved to 0.5%.
Second quarter data suggests that the economy has already exited the technical recession, Mohr and Odendaal say.
“For instance, retail sales posted a third consecutive positive month of annual growth in May. However, business and consumer confidence remain depressed.”
The SARB expects growth to improve somewhat to 1.2% in 2018 and 1.5% in 2019.
However, these “lacklustre growth rates” are completely out of sync with global growth and clearly too low to make any inroads into South Africa’s social problems (population growth is around 1.5%, so the economy is still shrinking on a GDP per person basis), say Mohr and Odendaal.
A single rate cut, such as was announced on Thursday, will not provide significant stimulus to the current environment of low confidence and political uncertainty.
“Given current conditions, further rate reductions are possible, providing some further relief,” they conclude.
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