Bianca Botes, Managing Director at Citadel Global
The United States (US) Federal Reserve (Fed) raised rates by 25 basis points on Wednesday, taking the Fed funds rate to 3.75% to 4%. This was the first-rate hike since July 2023 and while the unanimous vote was expected, the Fed’s tone was not. Fed Chair, Kevin Warsh – appointed by a US President, Donald Trump, who wanted lower rates and who responded to the decision by calling for rates of 1% or less – told reporters that inflation had been too high for too long and the Fed was removing a dose of accommodation (Fed speak for reducing monetary stimulus). The Summary of Economic Projections showed that 16 of the 18 submitting officials expect at least one further hike this year and futures now price in close to a 90% probability of that move, while the US 10-year Treasury yield holds near 5%, a level last reached in 2007.
What makes the decision hawkish rather than simply a move to target inflations, is the nature of the inflation being targeted. Much of the inflationary pressure stems from energy prices linked to the US-Iran conflict, which Warsh conceded monetary policy has no control over. So, the Fed is tightening not with the expectation that higher rates will lower the oil price, but because US inflation sitting above target for five years needs to be addressed.
The rand’s odd composure
Against that backdrop, the rand’s composure looks odd. The $/R exchange rate moved from around R16.23/$ before the decision, to roughly R16.30/$ following it. The currency then ran out of steam towards the R16.40/$ mark on a day when the dollar posted its strongest session in three months. The explanation lies in carry (the cost of holding a currency based on the interest rate difference of the two currencies).
Holding the rand is currently attractive, since the South African Reserve Bank’s (SARB’s) repo rate of 7% sits 300 basis points above the upper level of the Fed funds range and, with local consumer price index (CPI) inflation at 4.3% in July, it delivers a real policy rate close to 2.7% against a Fed real rate that is barely positive. That gap has been drawing capital, with global investors buying a net R23.1 billion of South Africa (SA) Government Bonds in the first week of August, the largest weekly inflow since January according to Johannesburg Stock Exchange (JSE) data.
Rand’s composure, however, in question
Stability built on carry is, however, only as durable as the capital behind it and SA’s balance of payments shows how much that capital is now being asked to hold – while gold, near $4,310/ounce, continues to support export earnings through price (even though mining output contracted by 3% in the second quarter), the country’s current account swung from a surplus of 2.3% of gross domestic product (GDP) in the first quarter, to a deficit of 2.6% in the second quarter, the widest spread since the third quarter of 2019 and twice the consensus forecast, as the value of crude oil imports rose by 82.1% on volumes up only 1.8%.
The reality is that country’s currency inflows follow the bond yield differential rather than the underlying economy and every support beneath the rand is exposed to the Fed’s decisions, because further tightening narrows the carry differential, lifts real US yields and weighs on gold, while the oil price driving inflation is widening the gap that must be funded by those inflows. With traders already pricing three Fed hikes through to June 2027, a currency financing a widening external deficit with hot money should be carrying a larger risk premium than the rand is currently carrying.
SARB balancing act
This places the SARB in a difficult position ahead of its decision on 23 September. The July interest rate hold came on a four-to-two split with both dissenters favouring a further 25-basis point hike and the 3% inflation target and its one-percentage-point tolerance band, places July’s 4.3% CPI print above the SARB’s target ceiling. This week’s Fed decision weakens the argument for patience, because the rand’s strength has been the principal factor containing import inflation, although the case for holding strengthened this week as GDP contracted by 0.2% in the second quarter and SA’s Bureau for Economic Research’s third quarter survey showed five-year inflation expectations easing to 4% and household 12-month expectations falling from 6% to 4.9%. These factors could all justify a hold, but with two members already voting to hike, a hold is more likely to carry hawkish guidance than to mark the start of an easing cycle.
The demand of a risk premium
The rand has already shown how quickly a risk premium can be demanded. When the SARB held rates steady on 23 July, against the expectations of 17 of the 20 economists surveyed by Bloomberg, the rand fell by more than 2% in a single session, the worst performance of any currency that day and came close to R17.00/$ the following morning, which is the impact of repricing a narrower differential in a market positioned for carry.
The rest of the year offers several opportunities for a repeat, with the SARB’s November Monetary Policy Committee (MPC) meeting, the US Mid-Term elections on 3 November, SA’s local government elections on 4 November and the December Federal Open Market Committee (FOMC) Meeting offering a potential rate hike, all potentially hitting the rand. In addition, Washington’s visa restrictions on SA officials, which the US has described as the first of several measures targeting SA, add a diplomatic risk the market has so far ignored.
Our advice to clients
The rand is, therefore, more likely to retest R17.00/$ level before year-end than to hold below R16.00/$. Importers and corporates with dollar liabilities should extend cover at current levels, since forward points of roughly 1.5% over six months cost less than half of what the rand lost in two sessions in July. For private clients, a rand near R16.30/$ and a 10-year US Treasury yield near 5% offer a better entry point for offshore allocations than the market is likely to provide once the deficit is priced in.
ENDS
