Well-known Investec economist Brian Kantor refers to it as the dropping of the shoe, when the reality of certain decisions start to see the light of day. The shoe is related to an upward movement in the United States federal reserve’s short term rates, with the market pricing in a 25bps hike in December, or as Kantor says ‘almost certain of doing so’. The market reaction to this has however been far more muted than the taper tantrum responses of 2013. The South African Reserve Bank is currently meeting behind closed doors for its Monetary Policy, and will deliver its decision on rates on Thursday. Given the muted market reaction to a potential US interest rate hike, Kantor is calling on the Reserve Bank to do as the markets have, remain composed. His argument reads below. – Stuart Lowman
By Brian Kantor*
The reactions of the Fed. The other shoe has dropped – thankfully for those living downstairs.
The first Fed shoe dropped in May 2013 when it announced it would soon be halting, or in its own words “tapering” QE, that is the purchase by the Fed of US government bonds and mortgage backed paper in the market place in exchange for its own deposits. In other words, the Fed signaled its intention to stop creating money, as it had been doing to the tune of an extra US$85bn a month. True to its word, by year end 2014, QE was suspended.
The reactions in the financial markets to this announcement in 2013 were quite dramatic, and especially so in emerging market (EM) equity, currency and bond markets, including South Africa. The rand lost over 12% of its US dollar value within a few weeks, from about R9 to the dollar at the beginning of May 2013 to about R10 at month end while the yield on the RSA 10 year increased from 6.3% p.a to 7.08% p.a by month end. The benchmark EM equity index, the MSCI EM, lost 10% of its value between May and June 2013 while the US dollar value of the JSE All Share Index lost 6.8% in US dollars over the two months.
The second Fed shoe has now dropped, which is perhaps just as well for those who have been waiting for it to hit the floor. The second shoe comes in the form of the upward move in the Fed’s short term rates, the first such increase since the financial crisis of 2008. An increase of 25bps in US short term rates in December now seems certain, or at least the market place has reacted as if it is almost certain.
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Market reaction to this news have been far more muted than the responses described as the taper tantrums of 2013. The rand has lost about three percent of its dollar exchange value since the September month end. 10 year bond yields are about 30bps higher in response to the now firm prospect of higher short rates in the US.
The shoe having dropped, is there more damage in prospect for the rand and the borrowing costs of the SA government? The answer will depend largely on ongoing investor sentiment towards emerging markets. Higher interest rates in the US and elsewhere are not welcome in hard-pressed EM economies. But confirmation that the US economy is firmly on a recovery track, is surely encouraging to all those EM businesses that trade with the US. A combination of strength in the US and less anxiety about the Chinese economy would surely be better news for EM economies and their longer term prospects that now appear so poor (as reflected in EM share markets that in US dollars are well down on their levels of September 2009, while the New York benchmark S&P 500 has been racking higher ever since).
The rand remains an EM equity currency. It continues to move in response to the US dollar value of the EM equity benchmark as we show below. South African events do not appear to affect the rand in any consistent or significant way.
The EM Index and the USD/ZAR (daily data 2015) The rand is an EM play.
The rand is little changed versus other EM currencies over recent days, though both the Turkish lira and Brazilian real have recovered some of their weakness against the rand. On a trade weighted basis, the rand, in line with other EM currency and equity markets, has weakened significantly since mid-year, though much of the damage occurred in August rather than very recently.
THE ZAR IN 2015 14% WEAKER ON A TRADE WEIGHTED BASIS (TO NOVEMBER 13TH)
The rand’s daily moves can be well explained by global market developments independently of SA political or economic developments (which cannot anyway be regarded as favourable). For example, as we show below, the rand rate against the US dollar can be predicted to closely follow trends in the US dollar / Australian dollar exchange rate, coupled with a measure of SA sovereign risk. Sovereign risk is measured as the premium investors would pay to ensure against SA government default on its debt.
The results of such a model are shown below. It suggests that the rand, now trading at over R14 to the US dollar, has overshot its predicted value of R13.50 or so.
We get a similar result and a similarly satisfactory model of the rand when we replace the influence of the Australian dollar with the MSCI EM and combine this with the credit default spread on US dollar-denominated SA debt. The rand appears somewhat oversold using these models.
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It is also clear that as the prospect of higher US rates has become more certain, the risks associated with EM debt, as measured by the spreads over US government debt, have also increased. The spreads attached to SA debt have widened largely in line with EM spreads generally. SA specific risks do not appear to have had a significant influence on these spreads recently. Higher spreads and higher interest rates in SA appear mostly as an EM rather than SA event. The Credit Default Swap (CDS) spread between SA dollar-denominated debt and the average EM (Brady Bond) spread has not altered recently. In a relative sense, SA debt lost some rating ground versus other EM borrowers by mid-year, however. The spread in favour of SA can be seen to have narrowed.
Long term interest rates in SA have followed modestly higher rates in the US as the near certain increase in short rates was priced into the debt markets. As we have mentioned, these increases can be regarded as modest to date.
The wider EM risk spreads have not led to any exaggerated movements in the yields on rand-denominated RSA debt. We must hope that the very little inflation expected in the US helps to continue to restrain the Fed from ratcheting up short rates and that long term rates in the US remain at historically low levels for an extended period of time. We expect very dovish Fed reactions, especially given the stronger dollar that will keep down the pressure on metal and mineral prices and make deflation rather than inflation the focus of Fed concerns.
Less upward pressure from US interest rates on SA rates (short and long) will be helpful for the rand and the inflation outlook in SA. Hopefully, less pressure will restrain the Reserve Bank from even thinking about higher interest rates. Higher rates in SA would not necessarily protect the rand should the dollar get stronger with higher rates in the US.
The other shoe – in the form of market reactions to higher interest rates in the US – may well have dropped. And the reactions in the market place to date reflect a much more relaxed response to the prospect of higher rates in the US than was the case in 2013. We must hope and encourage the Reserve Bank to also keep its composure.
- Brian Kantor is the Chief Strategist and Economist at Investec Wealth and Investment in South Africa.
