A visual roundup of Rates Indicators:
Bottom Line:
- There has been a massive reset in interest rate expectations. A massive drain on portfolio flows has kept the pressure on the ZAR in a way that has raised speculation of a stronger SARB response. There has been an avalanche of bad news in SA so far this year, and sentiment has soured. SA will now need to offer substantially deeper discounts to foreigners to invest in SA capital markets, and that will come in the form of substantially higher interest rates and a much weaker ZAR. Unless the SARB responds to accommodate the country’s risk profile, the risk is that the ZAR remains on the defensive and inflation unanchored.
- From where the market was pricing in just two more rate hikes of 25bp each at the next two SARB meetings, the market is now fairly convinced that the SARB will hike by at least 50bp at the next meeting, with a further two 25bp rate hikes after that. The FRA market shows that there is at least 100bp worth of hikes still to come, which is an effective doubling of what expectations were three weeks ago. Much has changed in the past two weeks, and the SARB is now backed into a corner. It only has interest rates at its disposal to try and contain the fallout of maladministration, and it should not hesitate to use them. The mistake people will make is to lay the blame for weak growth at the foot of the SARB, when in actual fact, the high interest rates reflect little more than the failure of the state to which the SARB needs to respond.
Baseline View:
- This week’s SARB MPC will be instructive. The SARB is under pressure to respond, lest it fuels even more ZAR depreciation. It is now likely that it will hike rates by 50bp, and follow that up with even more tightening thereafter. Although this is growth negative, it is the price SA now needs to pay for the years of maladministration of the economy.
Broad expectations
The aggressive sell-off in the rand in recent weeks has had a significant impact on the outlook for interest rates. The combination of the worsening electricity crisis, the optics around SA’s relationship with Russia, the effects of the greylisting and Reg-28 changes have delivered a bloody blow to the ZAR, which has depreciated nearly 14% against the USD year-to-date. This makes the ZAR the second worst-performing EM currency this year, lagged only by the Argentine peso.
More importantly, from an inflation perspective, is the year-on-year depreciation in the ZAR. This makes for sobering reading, with the ZAR losing almost a quarter of its value against the USD over the last year. The sharp depreciation in the ZAR, if sustained, will have a major impact on inflation in the coming months.
Risk to the Outlook
While international commodity prices have corrected lower in recent weeks amid a worsening global growth outlook and improved supply conditions, the positive impact on inflation is being offset by the weakness in the ZAR. The impact of the ZAR weakness on inflation expectations is evident when looking at SA’s breakeven rates, which have surged this month. For context, SA’s 5yr breakeven rate has risen nearly 75bps this month to 6.45% (4.68% in early February).
Against the backdrop of the sharp depreciation in the ZAR and soaring inflation expectations, both of which will concern policymakers, we have revised our forecast for the upcoming May MPC meeting to a 50bps hike. While this is our base case, we must flag that there is a reasonable probability that the SARB could deliver an even larger hike, in the range of 75-100bps, to help stabilise the weakening ZAR. At the time of writing, the FRA market was fully pricing in a 50bps rate hike and an 84% probability of a larger 75bps hike. The ZAR will be the primary focus for the MPC at its May meeting, given its impact on inflation expectations which have de-anchored amidst the latest blowout in the currency.
SARB needs to do more to help the ZAR
Although the SARB has hiked rates several times despite an economy struggling to produce any GDP growth, it is notable that SA interest rates are still amongst the lowest vs many other emerging market economies. Before the ZAR’s latest bout of weakness, the SARB looked to have another 50bp worth of rate hikes to announce, but risks have increased that the SARB will need to do more.
Even a 50bp or 75bp rate hike, either all at once or split over the next two MPC meetings, would still not elevate SA’s policy rate to a much higher ranking. Furthermore, many emerging market economies started hiking long before the SARB and hiked more aggressively. The result is that SA is a laggard on this very basic metric.
Of course, a policy rate does not equate to a bond yield, and SA’s bond yields are notably higher and offer very positive real rates, but perhaps the message is that SA must run with very high positive real yields in order to compensate investors for risk. It also implies that once the SARB hikes at least two times, rates may remain elevated for longer, while others may be quicker to reduce interest rates when inflation allows.
Global policy rates near their peak
After what has been one of the most aggressive coordinated global monetary policy tightening cycles, major central banks seem to be at the end or near the end of their rate hikes. As can be seen in the chart above, that market has very little chance of further Fed hikes priced in, while the ECB and BoE may still deliver one or two more, with the former still playing catch up after it lagged its peers in beginning its policy tightening cycle.
Not only has the market priced in a pause in the Fed’s hiking cycle, but rate cuts are now predicted to start in Q4 2023. The timing has shifted in recent weeks, but it is clear that the market is looking for any signs that the economy will need monetary support as the impact of the prior rate hikes is still filtering through.
A Fed that is easing its monetary policy while other central banks keep rates steady will pressure the US dollar significantly. This will help take the pressure off the SARB to hike rates from both a rate differential perspective as well as from a currency weakness perspective.
Inflation is finally peaking, domestically and abroad
Inflation has finally turned the corner. The combination of unprecedented rate hikes and liquidity withdrawal have started to exert downward pressure on inflation, and while the full effects of this monetary tightening eventually find expression in weaker or negative money supply growth, inflation will likely decline even further through the months ahead.
The expectation is that inflation heads back towards central bank targets, although it may not happen as quickly as the central banks would like. There was a tremendous amount of excess liquidity injected into the global economy through QE efforts to mitigate the effects of Covid that still need to unwind. However, given the magnitude of the liquidity injection, it will take time before liquidity has dried up sufficiently to tackle inflation once and for all.
The risk is that central banks will need to persist with higher interest rates and drain more liquidity over a longer period of time than first envisioned. For SA, that implies that investors should not be in a hurry to expect a reduction in rates too soon. On the contrary, given the impact of load shedding, massive electricity tariff increases, the weaker ZAR and much higher levels of risk associated with exposure to SA, domestic interest rates may be forced to remain far more buoyant for much longer, in a blow to the credit cycle. Such is the cost of maladministration and corruption.