Bottom Line:
- While the SARB, alongside other central banks, might talk hawkishly about hiking to tackle inflation, there is a limit to their tightening. While there is growth and rising inflation, the justification seems plausible. Remove the growth, and inflation turns the corner, and the SARB will find convincing people of the virtues of monetary tightening a lot more difficult.
- That said, the SARB is expected to front-load its hiking cycle as it looks to get a grip on inflation and inflation expectations. Thus, the professional market is pricing in the risk of at least one 75bps rate hike this year, as inflation expectations have continued to rise as the ZAR weakens. While the recent ZAR weakness will add pressure on the SARB to tighten policy aggressively, we continue to caution against turning overly hawkish given the recession risks facing not just SA but the global economy.
Baseline View:
The SARB will have to play a delicate balancing act between reining in inflation while not choking off the economy, which has been hit by unprecedented load-shedding and faces several structural constraints. The SARB will want to keep inflation expectations in check by showing markets that it is committed to its fight against inflation. As such, we expect the SARB to deliver another 50bps rate hike at its July MPC meeting, followed by two rate hikes of the same magnitude at the two remaining MPC meetings of 2022.
Broad expectations:
Since the last update, there have been some considerable developments. Internationally, Fed rate hike expectations have been re-priced higher after US CPI trounced expectations, increasing the possibility that the Fed could deliver an outsized rate hike later this month. Fed commentary in recent weeks suggests that it is possible that the Fed will deliver a 100bps rate hike this month. The hawkish shift from the Fed has provided a boost to the USD, which has hit two-decade highs as the monetary policy differential between the US and other major economies continues to widen. The surging dollar has come as a stern headwind for the ZAR, which has sold off aggressively over the past 6 weeks, increasing inflation risks. While the ZAR has come under considerable selling pressures, depreciating by more than 10% against the USD since the start of June, it is worth noting that international oil prices have corrected lower, with Brent crude now trading below $100/bbl.
Hawkish Fed talk and ZAR weakness raise the risk for an outsized rate hike
While the correction lower in international oil prices is encouraging, it is worth highlighting that the fuel subsidy that has been in place since April is set to come to an end. With domestic inflation risks skewed to the upside against the backdrop of rising interest rate hike expectations in the US, the professional market has scaled up bets for the SARB to turn more aggressive in its fight against inflation. The market is fully pricing in two 50bps and one 75bps hike for the remaining three MPC meetings this year. This would take the Repo rate to 6.50%, levels last seen at the start of 2020 before the SARB slashed rates to cushion the economy from the impact of the pandemic. While the implied rate hikes priced in by the professional market are plausible, we remain of the view that the SARB will stick to 50bps hikes in the remaining three meetings. The implied rate path in the SARB’s Quarterly Projection Model is significantly lower. That said, the model was last updated in May and doesn’t include factors such as the recent sharp depreciation in the ZAR.
Rates have a long way to go to get back to neutral
Given that there hasn’t been a rate decision since the last update of this report, SA’s Repo Rate remains unchanged and well below the neutral policy rate. The wide gap between SA’s Repo Rate (black line) and the neutral rate (red line) shows that monetary policy in SA remains accommodative.
While we continue to caution that the professional market is overly aggressive in the implied interest rate path, there is no question that the spread between the Repo Rate and the neutral rate needs to be compressed. With interest rates expected to rise another 150bps by the end of the year, the spread is expected to narrow considerably. Currently, SA’s neutral rate sits at around 6.75%. This implies that the SARB will have to hike the Repo Rate by 200bps to get rates to a neutral level. Our base case scenario suggests that the SARB will raise rates by at least 175bps in the current rate hiking cycle. The tightening is expected to come to an end in the first half of 2023, with inflation likely to cool in the first few months of next year as the high base effects and slowing global growth take hold.
International rates surge as central banks vow to contain inflation
Investors across most DM jurisdictions have moved swiftly to price in for more aggressive monetary policy tightening as global inflationary pressures continue to rise. Across Europe, the UK, and North America, bond yields at the short end of the yield curve have shifted sharply higher.
The rise in yields has outstripped the central banks’ actual rate hikes and is a response to the guidance given that aggressive tightening will be a theme for several more months, likely well into 2023. This forward guidance has meant that the markets are doing much of the heavy lifting with regard to tightening financial conditions, with the aim of softening the blow of monetary tightening in a bid to reduce the amount of actual tightening the central banks eventually implement.
The most recent rise in yields has been amongst the sharpest on record. This exuberance by the market in pricing in higher interest rates, therefore, may be overdone. Central banks will still need to keep tightening to contain inflation, but the damage being done to their respective economies is significant and will mean that these tightening cycles may need to be cut short relative to what is being signalled.
DM yield curves point to a weakening business cycle
While short-end rates are rising, the expected economic damage mentioned above has meant that longer-dated yields are not rising as quickly, giving rise to a general flattening trend across DM yield curves. Typically, the flattening of the yield curve is associated with a business cycle slowdown and is a result of the short-term rates (chart above) rising faster than the long-term rates.
This particular chart shows that the general trend for DMs is of a flattening yield curve, but the most pronounced is that of the US. This speaks to investors pricing in a heightened risk of US recession as the Fed hikes rates, and in turn, restrains economic dynamism.
Historically, the inversion of the US yield curve is followed by a recession within the next 6 to 18 months. This time around, however, the pace of tightening is something that has rarely been seen before and could lead to an economic slowdown and contraction in gross domestic output much sooner than previously observed. This outlook supports the thesis that global central banks will not be able to increase interest rates as aggressively and for as long as they currently suggest.
SA credit growth picks up but still not conducive to runaway inflation
Inflation has breached the SARB’s target band as external price pressures from surging oil and food costs continue to manifest. Local demand-side inflationary pressures, however, remain relatively subdued. Growth in both M3 and PSCE has accelerated recently, allowing for some demand-side pressures to build, but both have been significantly higher in previous years, suggesting that South Africa does not face a major risk of runaway inflation just yet. That’s not to say that we won’t see headline inflation rising further, as a weaker ZAR and still elevated global commodity prices will continue to filter through. It does, however, mean that once we see these pressures ease, so to will general consumer price inflation.
This will lessen the pressure on the SARB to hike rates aggressively to rein in inflation. Much of SA’s CPI growth is due to measures beyond the SARB’s control. It will still need to tighten to ensure that second-round effects are contained. But it will not need to hike rates to the extent that we have seen in other countries.
Fuel price increases are a large component of inflation
That said, the latest petrol price increase will likely embolden the SARB to hike aggressively again, but there is a strong negative growth component that one cannot ignore.
In June, the government decided to halve the petrol price subsidy to 75 cents from R1.50, and this contributed to the petrol price rising by between R2.37-2.57/per litre in June. In other words, fuel prices have at least another 75 cents to rise once the rest of the subsidy is removed at the end of this month. Fuel prices are now over 50% higher than they were a year ago, and they rose some 11% in just one month. The impact on inflation is significant and has pushed CPI further above the upper limit of the SARB’s 3-6% target range as it bolstered inflation by 0.5pp m/m and 2.6pp over a year.