Bottom Line:
- The economies of the US and Eurozone are proving more resilient than expected, while inflation is proving to be stickier than anticipated. As such, the markets have recently pared their expectations for a pivot from the likes of the Fed in the near term, with US bond yields rising back to December levels and traders increasing their expected terminal rates for all major central banks. This has culminated in some notable ZAR weakness given the local unit’s increased vulnerability amid intense loadshedding and economic uncertainty.
- South Africa’s inflation risks, therefore, are rising. Not only is the ZAR weakening, but food prices are still rising amid loadshedding disruptions, while fuel costs and other administrated prices will rise sharply in the months ahead. Offsetting this to some degree is the weakening outlook for the economy. The SARB will be cognisant of this, and will balance near-term inflation risks with what will surely be a notable slump in economic activity in the months ahead.
Baseline view:
Interest rates will rise a little further, but they are close to peaking with a 25bp hike from the SARB expected in March, followed by what could be a pause. Risks are rising amid ZAR weakness and persistent hawkishness from global central banks that further hikes could be forthcoming beyond March. The SARB will therefore remain data dependant going forward and the upcoming inflation prints will determine if more hikes are needed.
Broad expectations:
The start of 2023 has been a challenging period for rate traders. What looked like an unwavering pivot in global monetary policy is no longer as clear. Stronger-than-expected inflation out of the US and renewed global supply pressures, particularly food out of Ukraine and Russia, suggest that the global pivot may be pushed out a few months. US markets are fully pricing in another 25bps hike in March and considerable risk of more rate hikes in May and June. With a pivot in rates now only expected to come in September or in Q4.
Domestically, ongoing load-shedding and the impact on consumer prices, heavy rainfall which has destroyed crops across the country and renewed pressure on the ZAR have skewed inflation risks to the upside. The factors mentioned above have bolstered bets that we could see another 25bps rate hike from the SARB next month. As of Thursday, 16 February 2023, the FRA market was pricing in an 88% probability of a 25bps rate hike for March.
Risk to the Outlook:
The market pricing aligns with ETM’s house view, which we have communicated since last year. We expect that the SARB will conclude its tightening cycle with one final 25bps rate hike in March.
That said, given that inflation risks are skewed to the upside, and the rand has depreciated, the risk to the outlook is that an additional rate hike beyond March might be announced, particularly if the Fed continues to hike. The SARB wants to prevent a widening in the monetary policy differential between SA and the US, which would add to the headwinds facing the ZAR.
That said, ETM Analytic’s proprietary models suggest that despite the recent episode of ZAR weakness, inflation should moderate in the months ahead as the high base effects of last year take hold. Moreover, ETM’s currency models still point to a period of ZAR strength in the months ahead, which will help alleviate some pressure for consumers. It must be stated that we have moderated our expectations of how much inflation will slow as a result of the anticipated rise in domestic fuel prices and the impact of the recent floods and ongoing war in Ukraine on local food prices. Loadshedding will also continue to impact consumer prices as producers and retailers pass on higher input costs to consumers. Notwithstanding the revisions to our inflation projections, we expect rates to peak in H1 2023 and remain on hold for the rest of 2023. The shift in the cycle is expected to begin in early 2024.
ECB and BoE are expected to hike rates further in the coming months
While much of the focus at the moment is centred on the Fed, other major banks, including the ECB and BoE should not be overlooked. With inflation running hot in the Eurozone as supply-side cost pressures persist, markets are pricing in a combined 100bps worth of rate hikes in the coming months. Specifically, the market is pricing in two 50bps hikes, one in March and one in June. While interest rates are expected to rise sharply in the EU in the near term, the market is pricing in a pivot in interest rates from Q4 2023 amid expectations for a significant downturn in economic activity later this year.
In the UK, markets are pricing in around 40bps worth of rate hike risk, with interest rates seen topping out towards 4.50% in September before falling in the final months and into 2024 amid expectations for an easing in inflation pressures against the backdrop of gloomy economic growth conditions. In summary, while growth fears are intensifying with cracks emerging in the global economy, major developed market central banks are expected to remain hawkish in the near term, with more rate hikes still in the chamber. That said, markets are still priced for a pivot in monetary policy before year-end.
Renewed inflation pressures vs mounting growth risks
As is the case for much of the world, the SARB has to contend with a dichotomy of renewed upside inflation risks against intensifying growth risks. This makes the task at hand a difficult one for policymakers, who need to fulfil their primary mandates of ensuring that inflation is brought back within its inflation target while at the same time not bringing the economy to its knees. While price pressures from oil and wheat have moderated, risk to the outlook for both commodities are to the upside.
Therefore, the SARB will have to play a delicate balancing act next month both in terms of its policy move and its forward guidance, given how sensitive financial markets are to monetary policy at the moment. The January meeting clarified the path forward for interest rates in SA.
The SARB’s decision to deliver a smaller 25bps is a sign that it is concerned about the deteriorating growth outlook amid the worsening energy crisis. That said, the fact that 2 out of the 5 MPC members voted for a 50bps hike shows that the SARB is not yet comfortable that inflation and inflation expectations are under control.
Market inflation expectations
Given its impact on currency and fixed-income market pricing, it is worth delving into implied market inflation expectations to gauge whether the communication and aggressive rate hikes are doing their intended jobs. To assess this, we look at the 5yr breakeven rates of SA and the US. Note that breakeven rates are the difference between a comparable vanilla bond and an inflation-linked bond and are used to determine market-implied inflation rates.
Concerning SA, inflation expectations have fallen considerably since the end of September as growth concerns intensified and global commodity prices corrected lower. For context, SA’s 5yr breakeven rate fell from levels above 7.00% in September to a low of 4.68% at the start of February. While still well below the peaks seen in Q3 2022, inflation expectations have risen in recent days amid concerns over renewed supply-side price shocks.