Bottom line:
• The ZSI remains in positive territory, pointing to a phase of ZAR recovery in the months ahead. However, this may depend on prospective Fed policymaking. Should the Fed tighten monetary conditions as much as is currently being anticipated by the market, the USD will remain supported. That being said, the risk is that a lot has been priced in and that the Fed disappoints a market that is too asymmetrically positioned for an aggressive tightening cycle that could weigh too heavily on the economy and cause the Fed to walk back some of its hawkish guidance.
• Note that the USD is around 25% overvalued on a trade-weighted basis. The ZAR, for its part, is around 10%-15% undervalued. Accordingly, it is well-positioned to take advantage of potential USD weakness. The big risk for the ZAR, however, is that commodity dynamics deteriorate and weigh on SA’s terms of trade, which would limit its ability to capitalise on would-be USD vulnerability.


Baseline view:

The ZSI’s recent rise into positive territory suggests that although the ZAR may still depreciate from current levels in the short term, this will ultimately prove to be unsustainable with recovery over the medium term the anticipated outcome.

ZSI pointing to improved ZAR outlook
The latest update of the ZSI model is pointing to a phase of recovery for the ZAR, although it may still be subject to some short-term turbulence in the months ahead. As illustrated in the chart below, the smoothed headline index has tracked the unsmoothed index into positive territory, pointing to ZAR appreciation risk through H2 2022. This suggests that while the ZAR may still be subject to volatility as it faces significant inflation and monetary policy uncertainty, SA’s trade and current account surpluses will help it remain resilient and help the ZAR capitalise on any bouts of USD weakness.

Analysis of the ZSI’s subcomponents suggests that potential for monetary policy divergence between the US Federal Reserve and the SARB poses some risk to the ZAR-bullish outlook, reflected in rising implied volatility (in absolute terms and relative to other EM currencies). However, less aggressive hedging in the options market against ZAR weakness point to the balance of risks still being tilted slightly in favour of ZAR appreciation from current levels, with importers set to enjoy a round of more favourable conditions in the months ahead.

Fed policy uncertainty – where the ZAR could capitalise

Arguably the most important theme in global financial markets at present is uncertainty around the Fed’s policy outlook. In recent months, markets have positioned for a very aggressive monetary tightening trajectory, with more than 200bps worth of rate hike risk currently priced in for the next six meetings.

This is unsurprising given that Fedspeak has generally been extremely hawkish this year, with the central bank realising that it is behind the curve. At the Fed’s May policy meeting, Chairman Powell all but promised 50bps rate hikes at both the June and July policy meetings, while also announcing that the Fed would begin shrinking its $9trln balance sheet by $47.5bn per month between June and August, and then by $95bn per month from September.

However, with the US (and global) economy so much more leveraged than ever before, the risk is that such an aggressive tightening cycle would weigh heavily on the economy, and cause some undue volatility in the financial markets. Accordingly, the Fed may well follow through with aggressive monetary tightening in the early stages of the cycle to rejuvenate its credibility as an inflation fighter, but may need to backtrack on some of its guidance down the line.

USD overvalued, ZAR undervalued

Given just how much rate-hike risk is currently priced into the USD, it is not surprising that it is extremely overvalued against all the majors (see the chart below to the left). Accordingly, any signs that the Fed will not be able to follow through with its hawkish resolve could trigger an unwinding of this overvaluation. Simultaneously, the ZAR is ready to capitalise on any would-be USD correction, given its relative undervaluation (as reflected in the chart below to the right). With an undervaluation of around 10%-15% (on a PPP-adjusted basis), the ZAR’s propensity to sell off further has dissipated to some degree, while it is also now better positioned to respond to fundamental drivers.


Keep an eye on commodities
One fundamental driver that could affect the USD-ZAR in the months ahead is commodity prices. As the adjacent chart illustrates, high metals prices drove SA’s terms of trade to very elevated levels, and helped boost its export performance throughout the pandemic. However, the risk is that the price of oil – a South African import – remains elevated for a prolonged period. This would detract further from SA’s terms of trade and drive-up import costs significantly, in turn weighing on the ZAR.

It is also not clear whether the pandemic-era rise in metals prices will be sustained. As central banks across the globe normalise monetary policy, investors will question the sustainability of the rally. This poses a notable risk to the ZAR’s outlook, again suggesting that much depends on monetary policymaking in the developed world.


Author: Danny Greeff, ETM Analytics