USD is losing its shine as the US tightening cycle comes to an end
- Central banks remain in tightening mode, although it is important to note that the pace of tightening has slowed. In the coming months, the Fed is likely to reach for the pause button and at most, the market will accept one last 25bp rate hike. Much will depend on the resilience of the economic data scheduled in the next two months. Some soft readings will only heighten the probability that the Fed will reach for the pause button earlier than they have guided.
- The other two major central banks are lagging the Fed and have at least another one or two rate hikes left. However, a lot is priced in, so the conservatism of the SARB has stood the ZAR in good stead and helped it remain resilient, although it should be added that the ZAR has been amongst the worst performing EM currencies. It might’ve been a lot worse if the SARB had not kept pace with the rate hikes.
Bottom Line: Central bank decisions have been driving FX direction for a while now. They continue to do so, but will be looked at against the backdrop of the underlying data. If the data is strong and the central bank is hiking, the underltying currency could appreciate. Should the data soften and the central banks turn sensitive to growth, some currency weakness will follow.
Compressing monetary policy differentials are weighing on the USD
Monetary policy remains front and centre for financial markets as investors look for clues on the path forward for interest rates. The aggressive tightening in 2022 provided a boost to the mighty USD while at the same time triggering an unprecedented sell-off in other currencies, equities and bonds. The sharp rise in the USD last year came on the back of a widening monetary policy differential between the US and other major economies, such as the UK and the Eurozone.
However, the tide is turning, and the bullish bias in the USD is fading as the US’s monetary differential compresses as the US’s rate hiking cycle comes to an end.
Moreover, it is worth noting that the speculative market has shifted from holding net bullish positions on the USD for the better part of two years to net short as bets intensify that the Fed will slow its pace of monetary policy tightening, which should continue to detract from the US dollar’s performance and support bets of a further correction of its overvaluation. Simultaneously, other major central banks are expected to remain resolute in their rate-hike cycles through the months ahead, meaning the dollar is likely to lose more of its relative attractiveness. This is evident in the chart above that plots the market’s implied interest rate paths for the US, UK and Eurozone.
This offers clear context as to why the SARB has hiked. In following the Fed, the SARB has reduced the potential for negative speculation on the ZAR and helped mitigate what might’ve been a more pronounced inflation episode. The SARB’s conservatism achieved this by protecting the spread between SA and its major trading partners.
US rate decision – 25bps hike
The main event this week and arguably of the year so far was the FOMC rate decision on Wednesday evening. As expected, the FOMC unanimously voted in favour of a 25bps rate hike, taking the Fed Funds target range to between 4.50% and 4.75%. Wednesday’s move brought the cumulative rate hikes over the past year to 450bps. The big takeout from the FOMC forward guidance is that there are at least two two more rate hikes to come, 25ps in March and 25bps in May.
While the FOMC statement implied that there are at least two more rate hikes in the post, 25ps in March and 25bps in May, the market didn’t buy into the Fed’s guidance that it would raise interest rates at least two more times in the current tightening cycle. The swap market is pricing in a terminal rate below 5.00%, while the Fed guidance implies a terminal rate of 5.25%. As the market sticks to its guns that the US tightening cycle is nearing its end, so the USD has continued to weaken with the greenback falling to its lowest level since April 2023 and the monetary policy differential between the US and other major economies compresses.
UK rate decision – 50bps hike
The Bank of England (BoE) delivered another outsized 50bps rate hike, taking the Bank Rate rate to 4.00%. Recall that rates in the UK were at 0.10% during the pandemic era before the BoE embarked on its aggressive tightening cycle, which began at the end of 2021. While the BoE statement had a hawkish tone to it, the market overlooked this guidance and instead focussed on the growing risk of a recession later this year, which it expects will trigger a turn in monetary policy. Gilts rallied hard on the back of the BoE statement, which clearly failed to convince the market that rates would rise much further from current levels.
Eurozone rate decision – 50bps hike
Similarly, the ECB stuck with its guidance and delivered another 50bps rate hike on Thursday, bringing the Main Refinancing Rate to 3.00% from 0.00% just seven months ago. The guidance provided alluded to another 50bp increase in March, although this was not surprising given the hawkish commentary from President Lagarde. Interestingly, the statement also alluded to the decisions being data-dependant. This suggests that the ECB sees inflationary pressures remaining elevated, at least over the next few months.
The shift in monetary policy and the impact on the ZAR:
The market’s outlook on US rates and its impact on the greenback has seen the USD-ZAR come under considerable selling pressure this week, with the pair falling below the 17.0000 mark for the first time since mid-January. ETM’s proprietary models broadly predict that the downward trend in the USD-ZAR will persist in the months ahead as the USD unwinds some of its overvaluation. The chart to the right shows that the USD-ZAR is trading around the 75th percentile of its historical range from its fair value. This suggests that as the dollar corrects lower, the USD-ZAR should move towards its statistical fair value. While mean reversion theory suggests that we could see the pair fall to levels as low as 15.0000, there is a risk premium that needs to be factored in for risks such as load-shedding. That said, we are still of the view that the ZAR will likely appreciate to levels as low as 16.0000, if not lower, within the next 3-6 months, notwithstanding another exogenous shock.
ZAR bulls also managed to capitalize against the EUR this week as the market assessed ECB President Lagarde’s comments to be less hawkish than was priced for as traders focussed on the policy path beyond March. As inflation risks in the Eurozone ease and growth risks intensify, the market has trimmed expectations for how high rates will go in the current tightening cycle. The ECB committed to another hike of the same magnitude in March and said it would be data-dependent beyond that. With the ECB likely nearing the end of its hiking cycle, the strength of the shared currency against the ZAR is expected to subside as risk appetite recovers amid an easing in global financial conditions, as reflected by the recent rise in the Bloomberg Financial Conditions Index. Similar to the USD-ZAR, the EUR-ZAR is also hovering around the 75th percentile of its statistical valuation range, implying that the EUR-ZAR is primed for a correction lower when looking at the adjusted fair value, which sits at around 16.0000 currently.
According to ETM’s Adjusted Fair Value Model, the GBP-ZAR is trading close to its statistical fair value. While SA is facing a number of idiosyncratic challenges, so is the UK, which helps explain why the ZAR is performing relatively better against the GBP than the USD and EUR. Headwinds facing the GBP include political uncertainty, the impact of Brexit on the UK’s trade account and the ongoing inflation crisis that comes against an imminent recession, which will prevent the BoE from raising rates much higher than current levels. According to the IMF’s latest projections, the UK is projected to enter into a recession this year, with economic activity expected to contract by 0.6% this year. Although there is scope for a drop in the GBP-ZAR in the months ahead, ETM’s proprietary models suggest that the ZAR is likely to perform better against the USD and EUR over the next 3-6 months when considering the sizeable overvaluations in the USD-ZAR and EUR-ZAR.