Bottom line:

• Instinctively when one sees forward points compress on the USD-ZAR, questions arise about whether that implies rising vulnerability to a ZAR sell-off. However, the study below highlights why it is important to understand the context. Forward points are just one factor to consider. Expectations of what might happen to inflation and interest rates are equally important. Just as important is the valuation of the USD and whether it offers scope for any gains.
• Currently, the USD is overvalued, tighter monetary policy well established, and inflation is on its way back down. With so much priced into the USD, investors are uncomfortable establishing long USD positions, regardless of how compressed the forward points might be. One of the basic rules of investing is to avoid investing in an expensive asset. The USD is trading at some of the most expensive levels in over forty years.

Baseline view:

Although forward points have compressed, ETM does not judge this to be a danger signal pointing to negative ZAR speculation and further ZAR depreciation. The USD’s overvaluation against moderating inflation expectations and less hawkish US monetary policy still has the scales tilted toward ZAR appreciating through 2023.

Financial markets at the mercy of the Fed

This week the US Federal Reserve hiked rates by a further 75bp for an unprecedented fourth consecutive meeting. This decision raised the Fed Funds rate to the highest level since 2008, and the probability exists that rates may rise even beyond those peaks. Fed Chairman Powell so much as indicated that the benchmark rate would peak at a level higher than initially anticipated, although he refrained from offering an actual level.

The aggression of the Fed’s monetary policy stance through the past year has squeezed the spread between the US and SA benchmark rates, although the squeeze will ultimately be cyclical and transitory. Furthermore, the SARB has been quite responsive to the moves by the Fed and hiked in lockstep to ensure that the spread between SA and the US does not narrow too much. The next SARB meeting will yield yet another rate hike of at least 50bp and possibly another 75bp.

US Inflation and rate expectations turn lower

Following the most recent decision by the US Federal Reserve, it is significant that Fed funds rates expectations have not risen significantly. The broader trend lower in so far as expectations are concerned remains intact. It is an indication that investors are now looking through the cycle, and while they expect rates to rise a little further, the bulk of the hiking is behind us.

This chart is an early warning of a change in the dynamics that will affect US Treasuries and the USD. Interest rate expectations as reflected by the blue-shaded area, shows that rate hike expectations have moderated in line with what one would expect to see towards the end of the hiking cycle.

As the lagged effects of the rate hikes already implemented manifest, investors will steadily downgrade their expectations for further hikes, especially in the context of Fed Chairman Powell’s guidance that the Fed is now in the final phase of rate hikes. Through the course of 2023, expectations will gradually shift back to neutral and then tilt into negative territory around mid-year as investors position for the prospect of rate cuts.

Forward points compress

While the Fed is actively tightening monetary policy more aggressively than most, investors in the financial markets are pricing in such tightening into money markets. The forward points on the USD-ZAR have compressed, and while they were stable throughout 2019 into 2021, the Fed’s more aggressive guidance on tightening has seen US money market rates rise faster than SA rates.

South Africa has lower inflation than most DM countries, has weak growth with many structural constraints and a central bank that will come under greater pressure to consider the impact of all this tightening on the economy. Unemployment rates are still high, as are bond yields, and a hawkish SARB will do little to help the SA economy’s growth prospects. Compressing forward points show how investors do not believe that the SARB will be in a position to follow the Fed one-for-one and that its inflation and rates outlook will be more moderate. Given this compression in forward points, the debate turns to whether the ZAR is susceptible to further volatility, given the reduced cost of speculating against the ZAR.

   

USD valuation

To answer the question of whether speculators would bet against the ZAR, one must also consider the valuation of the USD. While the forward points may have compressed to raise the possibility of
negative speculation against the USD, it is less likely that speculators would want to rotate into a currency that is believed to be overvalued.

The accompanying chart highlights how the USD is at some of its strongest levels since the mid-1980s. Historically such levels have been difficult to sustain, implying that any negative speculation against the ZAR would need to feel comfortable about the idea of rotating into an extremely expensive USD.

It is unlikely that the forward points on their own would be enough to encourage wholesale rotation into the USD when a reversal in the USD could inflict so much more pain on a long USD trade, if funded out of ZAR. It would require something more substantive to trigger such speculation against the ZAR, and given the amount of bad news already priced into SA markets; It is unclear what that might be.

ZSI pointing to a strong ZAR recovery vs USD in 2023

The reluctance of the professional market to speculate against the ZAR is also neatly highlighted in ETM’s ZSI, which has continued to power from strength to strength, highlighting the expectation by investors that the ZAR will gain substantial ground vs the USD throughout 2023.

This indicator effectively shows the demand for hedging against ZAR weakness, and judging from the surge in the ZSI; there is very little appetite for hedging against ZAR weakness from current levels. Not only is the ZAR not overvalued on a trade-weighted basis, but the USD (as reflected in the chart above) is trading at very expensive levels.

The implication is that compressed forward points, on their own, will not be the reason why any negative speculation takes place against the ZAR. It would require something else to scare people against earnings the ZAR’s positive carry.

Carry attractiveness slips but is still alive

Dashboard of ZAR Drivers

Carry attractiveness has slipped down the rankings this year. There was a point when the ZAR’s carry attractiveness was second and third from the top, implying great support for the ZAR. That carry potential has dissipated somewhat, but importantly, the ZAR remains in the top third of currencies in this twenty-two-country ranking.

Ranking seventh out of twenty-two currencies is hardly a good reason to sell a currency. In the relative world of currencies, a ranking this high implies there may be many candidates better suited to negative speculation than the ZAR. It is unlikely to be singled out as a vulnerable currency deserving of depreciation in the way that the TRY, the GBP or the USD might be.