May MPC: SARB front-loads its hiking cycle, policymakers highlight growth risks

Posted on by Maria Joubert

Balance of risks table as per MPC statement

Dovish

 

  1. China’s covid-zero policy and the sustained invasion of Ukraine are weighing on global growth.
  2. Global growth forecasts revised lower, SARB expects global growth of 3.5% (from 3.7%) in 2022 and 2.7% (from 2.8%) in 2023.
  3. SA’s growth projections were revised down to 1.7% (from 2.0%) for 2022. SA’s economy is expected to expand by 1.9% in both 2023 and 2024.
  4. Load shedding and infrastructure and policy constraints are dampening SA’s growth outlook.
  5. Core inflation forecasts revised down to 3.9% (from 4.2%) for 2022 due to lower services prices.
  Hawkish

 

  1. QPM model now shows the Repo rate at 5.3% by the end of 2022, up from 5.06.
  2. Inflation forecasts were revised higher, with CPI expected to average 5.9% this year and 5% in 2023.
  3. Oil prices forecast remained unchanged at $103 per barrel. Power price increases forecast also remained elevated at 9.2%.
  4. Risks to the inflation outlook are skewed to the upside given rising food costs and the above-mentioned fuel price and electricity increase estimates. Food inflation is expected at 6.6% this year.
  5. Inflation expectations have risen, although they remain below the SARB’s forecasts.
  6. Although fiscal risk has eased on the back of better tax revenue, financing conditions remain tight and the yield curve remains steep.
  7. Capital flow and market volatility is expected to remain for emerging market assets and currencies.
  

Implications for SA markets

FRA:

The front end of the FRA curve was little changed after the announcement, suggesting that the market had already priced in the 50bp rate hike. However, some receiver bias has emerged at the long end of the curve. While FRA’s are now off their recent peaks, the rate hike risk priced in remains notably higher than the SARB’s guidance despite the upward revision in the central bank’s interest rate forecasts. The QPM interest rate projections were revised higher for 2022 to 5.30% (vs 5.06%) and 2024 to 6.74% (vs 6.68%). Given that today’s announcement was likely a front-loading of rate hikes which will lead to less aggressive tightening further down the line, the market still seems overly hawkish. We should, therefore, see the FRA curve flatten and spreads compress over the near term.

IRS:

The front end of the swap curve was subject to some receiving interest following the announcement with the 1y to 2y swap rates retreating. It is also noteworthy that the 1v2y swap spread is trading at levels last seen through Q2 2021. The market is responding to the firmer ZAR currently but is still pricing in sustained inflation and more rate hikes in the coming months, as evidenced by a longer end swap curve that is lagging the move lower. This is represented by the 10v2 swap spread, which is trading at a year-to-date low and its lowest level in more than two years. Economic growth risks could keep longer-dated swap rates lower, and thus, we could see some flattening of the curve in the near term. Given that the market still seems excessively hawkish, receiving at current rates may provide some value to investors.

Bonds:

Post the 50bps rate hike some flattening pressure has emerged along the SAGB curve with bonds broadly firming. More pronounced moves have been observed at the belly to long-end of the curve with the market pricing in the weaker growth outlook amid the downward GDP revisions. The R2048-R186 spread, for example, has narrowed slightly to just below 264bps from 267bps yesterday, suggesting that much was already priced in. However, we could see the curve flatten further in the near term as the ZAR will find some support from the aggressive rate hike, and growth expectations are revised to the downside.

ZAR:

Heading into today’s SARB policy update, there was plenty of two-way risk facing the ZAR. There were good cases for both a 25bp and a 50bp rate hike, and although the market was leaning towards the latter, it was never fully priced in. This was evident in the ZAR’s reaction to the 50bp rate hike that was ultimately delivered, as the currency surged more than 1% before consolidating around a two-week high of R15.8000/$. While some of this move can be attributed to broader USD weakness on the day, the ZAR’s outperformance of its EM peers suggests that the rate hike provided additional tailwinds that could help it sustain the break below the R16.0000/$ handle.

Bottom Line:

  • In line with consensus expectations, the SARB’s MPC decided to hike the Repo by 50bps, taking it to 4.75%. The vote was 4-1 in favour of a 50bps hike, with one member voting for a 25bps hike.
  • The decision was based on the fact that inflation risks are assessed to be skewed firmly to the upside amid soaring international food and oil prices.
  • The QPM model’s implied rate path was revised high with the Repo Rate now forecast to end 2022 at 5.30% and 2023 at 6.21%, respectively. Growth risks meanwhile remain acute amid lingering structural impediments including the continued electricity supply constraints.

Analysis:

  • South Africa’s inflation remains within the SARB’s target band, it is forecasted that it will breach the band in the second quarter of this year, however, if it does move outside of the band, we expect it to only be for a temporary period and potentially to a lesser extent than is currently being priced in.
  • Inflationary pressures remain skewed to the upside, with supply-side pressures being a main contributing factor. Fuel and food prices have risen to record highs over the past few months, and it does not seem as if these supply pressures are going to start easing soon. National Treasury has also not announced if it will be extending the fuel levy which could lead to a bump in inflation through the rest of the year, which could complicate the SARB’s policymaking.
  • Hiking rates is not going to have a material impact on the external supply-side effects that we are going to be exposed to in the upcoming months. However, the SARB may be hoping that high rates will support the weak rand and limit any second-round inflationary effects.
  • Higher rates support the currency’s trade appeal and the hike shows the market that the SARB is committed to its primary objective of price stability. These factors should underpin the ZAR over the medium term. That said, it is unlikely to shelter the ZAR in the event of a full-scale blowout in emerging market currencies.

Going forward:

  • While the ZAR has been depreciating over the past few weeks as a result of the stronger USD and deterioration in risk appetite, our internal models suggest that it is unlikely that the rand will see a complete blowout. SA’s fundamentals are healthy compared to other EM’s. From a fundamental point of view improvements in SA’s current account are supporting the ZAR’s resilience. Weak growth and the return of load shedding are undermining the ZAR’s resilience.
  • On a valuation basis, the USD is overvalued by 20% and the ZAR is undervalued by 12%, this supports the notion that the market is overly hawkish in its assessment of the implied path for interest rates given the limited risk of currency passthrough. Moreover, it suggests that the SARB does not need to hike rates as aggressively as the market is pricing for. We have seen the 50bps hike provide a boost to the ZAR’s carry appeal and has resulted in a significant appreciation in the currency in the wake of the rate decision.

In conclusion, we remain of the view that the market is overly hawkish in its implied interest rate outlook. However, on the back of the dovish statement, we are seeing medium- and long-term interest rate expectations moderate. Our view is that the SARB will hike rates by 25bps at least twice more during the remainder of the year and will then leave rates unchanged going into next year.