Forex Investment and Currency Trading

The South African Reserve Bank disappointed markets by raising its repo rate by ‘only’ 50 bps today. Hawkish rhetoric from several MPC members in the run-up to the June meeting had encouraged market expectations for a more aggressive interest rate move, and a full 100 bps had been priced in. The SARB Governor himself had spoken of the need to take ‘drastic’ action to rein in inflation, and when pushed to explain what ‘drastic’ might mean, said that even 200 bps was possible. Unsurprisingly, the ZAR weakened sharply on the back of today’s rate decision.

While a 50 bps rate hike is a measured response to evidence that the economy is slowing, the problem is that market expectations for a more dramatic move had largely been created by the SARB itself. As such, new doubts about the credibility of the Reserve Bank’s inflation targeting framework, or at the very least – how that is communicated to markets, will resurface.
The SARB has revised its own inflation forecasts, now expecting that CPIX will peak at 12% later this year, returning to target by Q3 2010. However these forecasts do not account for the possibility of a greater-than-inflation increase in electricity tariffs. Although South Africa has backed away from an all-in-one go 53% hike in electricity prices, a sharp increase in electricity prices is nonetheless more probable than not. Inflation is likely to peak at a higher level than the SARB forecasts indicate.

Together with the SARB’s admission that broadbased inflationary pressures are intensifying, the risks are very firmly weighted to the upside. Yet, there is evidence that earlier interest rate tightening is having an effect on the economy, with household expenditure, credit growth and the economy itself slowing. Household debt as a percentage of disposable income now stands at 78%, and may well have been a factor in the SARB’s decision not to tighten interest rates more aggressively. This reasoning is difficult to fault. Given the risks to the economy, perhaps 50 bps was the appropriate response. But markets, having been set up to expect more, will not like the decision. The ZAR will bear the brunt of the fallout. This in itself creates an additional source of inflationary risk that South Africa does not presently need.

Also weighing on the ZAR is the news that the current account deficit for Q1 (due for release with the SARB Quarterly Bulletin next week) is likely to have come in at +/-9% of GDP. This is huge, and highlights that the current account deficit may have widened further, despite the deceleration in economic growth in Q1. While the immediate blame may lie with oil prices, the fact remains that in this risk environment, with South African growth slowing (a negative for equity-related flows) and inflation spiking (a negative for the bond market), the current account deficit will be that much more difficult to finance. The risks to the ZAR are clear.

Going forward, market expects one more rate hike of 50 bps at the Aug MPC meeting. With South Africa having backed away from a very sizeable electricity price increase, there is unlikely to be a need for more aggressive tightening all in one go. While nominal yields will be more attractive, with inflation accelerating even faster than monetary policy is tightened, real interest rates are likely to become more accommodative. A higher nominal yield will count for little when it comes to preventing further ZAR volatility.