A visual roundup of Rates Indicators
Bottom Line:
- There has been a notable repricing in the market-implied interest rate path since the publication of the March Rates Dashboard. FRA markets have scaled up bets for more aggressive tightening in the months ahead with at least 50bps worth of rate hike risk being priced in. The readjustment higher in interest rate expectations has been driven by five main factors, sustained currency weakness, the impact of load-shedding on food prices, a marked increase in electricity costs, a surprise oil supply cut by OPEC+ and hawkish guidance from the Federal Reserve.
- While additional policy tightening from the SARB would provide support for the ZAR, which would help ease supply-side inflationary pressures, the SARB will need to consider the impact that additional rate hikes would have on the economy. SA’s economic outlook is already gloomy, with load-shedding expected to intensify in the winter months. Therefore, the SARB will likely conclude its tightening cycle in May with a final 25bps hike. Should the ZAR remain under pressure, the SARB could be forced to hike rates further in the following months. Therefore, although unlikely, further policy tightening beyond May can’t be ruled out.
Baseline view:
While it looked like March would be the end of the current tightening cycle, inflation is stickier than many had expected. This is partly due to sustained ZAR weakness, which is amplifying supply-side inflation pressures. Against this backdrop, we now see the SARB hiking rates by a further 25bps in May, which would take the Repo Rate to 8.00%, a level not seen since 2009.
Broad expectations:
There has been a significant repricing in interest rate bets in the FRA market since the publication of the March report. A surprise supply cut by OPEC+, which has provided support for international oil prices, sustained rand weakness and hawkish rhetoric from Fed officials, has seen FRA traders price in at least an additional 25bps rate hike since the March report. As of Thursday, 20 April, the FRA market was fully pricing in at least 50bps worth of rate hikes in the months ahead.
Whether that is in the form of another outsized 50bps rate hike next month or one 25bps hike in May and another in July is not 100% clear. The repricing in SA’s implied interest rates comes on the back of a readjustment in interest rate expectations in the US, with the US OIS market now pricing in material risk for rate hikes in May and June.
Risk to the Outlook:
While we see room for more policy tightening from the SARB in the months ahead as supply-side price pressures continue to run hot, aggressive hiking of rates from these levels seems like an overkill, given SA’s gloomy economic outlook and the already restrictive lending conditions. This will be particularly true if the ZAR regains its footing in the months ahead, as implied by ETM’s proprietary FX models.
Although headline inflation rose in February and March, we remain of the view that inflation will fall back within the SARB’s 3-6% inflation target range in the months ahead as the high base effects of 2022 come into play. To underpin this point, we don’t need to look further than domestic fuel prices. Should the fuel price stabilise around current levels in the months ahead, we could see deflation in domestic prices of as much as -14% in Q3. This would significantly impact the transport component of the inflation basket. There are however a number of upside risks to the inflation outlook. These include increased energy costs, a sustained rise in food prices if the loadshedding crisis worsens and a further depreciation in the ZAR play out.
ZAR and soaring food costs are the most significant risk to SA’s inflation outlook
The March inflation report published this week showed that while a theme of easing inflation globally is playing out, SA’s idiosyncratic factors are keeping price pressures elevated locally.
A weaker rand, the cost of insulating from load-shedding and other infrastructure failings, and enormous electricity tariffs are all factors driving a slower-than-expected fallback in inflation. A breakdown of the inflation report showed that food and non-alcoholic beverages prices rose by 14% y/y in March, the largest annual rise since March 2009. Milk, eggs and cheese, confectionary, and fruit and vegetables were the most affected items, according to StatsSA.
The ZAR meanwhile has come under considerable selling pressure over the past 12 months, depreciating by more than 16% against the USD. The ZAR has been the fourth worst-performing emerging market currency tracked by Bloomberg over the past 12 months, underperformed only by the Colombian Peso, Turkish lira and Argentine peso. The sharp depreciation in the ZAR is compounding the price of imported goods, thus keeping imported cost price pressures elevated. It is also boosting parity pricing pressures on food stuffs and commodities produced and sold locally. At a nominal price level, the ZAR weakness is largely offsetting the correction lower in international commodity prices that has unfolded in recent months.
The impact of the ZAR weakness is apparent when looking at the ZAR oil price versus the USD oil price. For context, the USD price of oil is down by around -24% over the past 12 months, while the drop in the ZAR price has been substantially smaller over the period. This has resulted in elevated domestic fuel prices. While domestic fuel prices have fallen from the peaks seen in July 2022 when the inshore 95 petrol price reached R26.74/l, the pullback in fuel prices has not been as pronounced as it would’ve been were it not for the sustained ZAR weakness. Note that domestic petrol prices rose for a third straight month in April, primarily due to ZAR weakness.
Since the start of February, the ZAR has depreciated by more than 4% against the USD. Notwithstanding a fairly solid crop harvest in the most recent farming season, as highlighted above, food prices have continued to surge. Beyond parity pricing pressures, irrigated farming operations have struggled amid load shedding and farmers have openly requested to be exempt from load-shedding lest they are forced to produce far less or produce more expensively, both very inflationary.
What is driving the ZAR weakness?
One of the main factors weighing on the ZAR is the exodus of foreign capital from the local bond and equity markets. As seen in the chart to the left, foreign holdings of SA equities and bonds have fallen dramatically this year as investors weigh in on the perfect storm of domestic and external factors that has hit SA.
On the international front, global risk-off conditions, driven by the US banking crisis, mounting geopolitical tensions and surging interest rates resulting in a marked decline in global dollar liquidity, have hit domestic assets. Locally, SA’s deteriorating fiscal outlook, the recent greylisting, Transnet shortfalls affecting coal exports, SOE failures, mounting political uncertainty ahead of next year’s presidential election, Regulation 28 changes and ongoing structural issues such as load shedding have weighed on foreign sentiment towards SA.
Recent National Treasury data has revealed that the South African bonds market has experienced -R40.5bn of foreign outflows over the last two months. Over the past two years, since recovering from the COVID-19 lockdown, growth in nominal foreign holdings of vanilla bonds has been stunted. Not surprisingly, there is a strong correlation between the decline in the foreign holdings of SAGBs and the performance of the ZAR. This is visible when looking at the close link between the black line (foreign holdings of SA vanilla bonds) and the red line (year-on-year change in the USD-ZAR, which has been inverted for ease of interpretation) (a move lower is reflective of ZAR weakness).
ZAR weakness has likely run its course
While a number of idiosyncratic risks still plague SA, currency fundamentals suggest that the period of ZAR weakness may have run its course. The steep depreciation in the ZAR over the past couple of months has left the currency significantly undervalued. Specifically, ETM’s PPP currency valuation model currency has the ZAR as being -15% undervalued vs the USD. History shows that when the ZAR reaches such stretched levels of undervaluation, it is typically followed by a period of ZAR appreciation.
While the ZAR could still depreciate further in the near term, as the accompanying chart shows, a move beyond the 90th percentile (top upper dotted band) cannot be sustained. The previous two times that the ZAR has reached a point of extreme undervaluation over the past decade, it has appreciated beyond its adjusted fair value (red line), which is currently around 16.00 a year from now.
The significant undervaluation in the ZAR comes on the back of an overvalued USD and many domestic risk events. An expected divergence in monetary policy between the US, the UK and the EU will likely result in a correction lower in the USD in the months ahead, something the ZAR could capitalise on given its improving carry trade credentials. Furthermore, there is a marginal structural shift away from the USD at the moment, with some countries choosing to transact in their own currencies, excluding the USD in the trade. In summary, the USD looks poised for a correction weaker over the next 3-6 months. The latest CFTC data shows that speculators have already turned net bearish on the USD.
A meaningful appreciation in the ZAR would go a long way in helping to ease supply-side inflation pressures in SA, which remain stubbornly buoyant.