The rand has reversed the severe losses it sustained after US ambassador Reuben Brigety’s recent accusation that South Africa sold arms to Russia last year. This is despite lingering geopolitical tensions between the two countries and most people’s view that the Federal Reserve is not done hiking rates in the US.
In the wake of the furore surrounding Brigety’s announcement and the related matter of the Russian ship Lady R, the rand-dollar exchange rate hit a record R19.92/$ level in May. In a dramatic move, it had recovered to R18.18/$ by late last week. (However, it had weakened back to R18.48/$ at the time of writing.)
While the markets were still digesting the speed of the recovery, they received a second dose of good news: consumer inflation for May had fallen to a 13-month low of 6.3% year on year from 6.8% year on year in April, soundly beating consensus expectations.
The outcome reflects mainly a marked slowdown in food and transport inflation, driven by receding global inflation and helpful technical base effects. (The international Food & Agriculture Organisation food price index has decreased by 22% since its record high in March 2022, and continues to drop.)
Inflation is now within a whisker of the upper end of South Africa’s 3%-6% target band. It is expected to keep slowing as base effects become more pronounced in the coming months, easing pressure on the Bank.
“We can say it loudly now: no further Reserve Bank hikes appear to be required in this cycle,” cheered Standard Chartered chief economist Razia Khan, one of the first to respond to the consumer price index (CPI) surprise.
However, several economists still expect the hawkish monetary policy committee to deliver one final 25 basis point (bp) hike at its July meeting to cement inflation’s downward trajectory. The forward rate agreement (FRA) market is also factoring in one more 25bp hike in the current cycle, but only towards the end of the year.
Nedbank regards the latest CPI surprise as “encouraging”, as it suggests that inflation could continue to decelerate faster than the market expects. But it notes that base effects amplified the deceleration. On the other hand, core inflation (CPI minus food and fuel prices) eased only slightly to 5.2% year on year in May from 5.3% year on year in April.
The “stickiness” of core inflation is explained by high domestic production costs and a weaker rand — factors that Nedbank expects will continue exerting upward pressure on inflation. This will partly counteract the continued downward pressure from receding global inflation, especially sharply lower international oil and food prices.
“Given the many uncertainties surrounding the inflation outlook, especially the rand’s murky prospects amid persistent geopolitical risks and the US Federal Reserve’s hints of further rate hikes, the Reserve Bank will likely remain hawkish,” says Nedbank. “We still expect one more rate hike of 25bp in July.”
Citi’s take is that both food and core inflation have peaked, and that the CPI will fall meaningfully again in June, possibly to as low as 5.4% year on year. The 72c/l petrol price cut in June will help.
Also positive is that the prices of fewer than 5% of items in the consumer basket are still rising compared with 60% previously. This should minimise second-round effects, says Citi economist Gina Schoeman.
In addition, it matters that core goods inflation fell to 7.5% year on year from 8.2% year on year, as it is the CPI goods basket (as opposed to the services basket) that tends to drive inflation expectations. How quickly inflation expectations respond to the lower CPI readings by trending towards the midpoint target will be a key determinant of whether the Bank raises the rates again.
Schoeman, too, believes the Bank will hike once more by 25bp in July to cement the slowdown in inflation.
In an eNCA interview last week, Bank governor Lesetja Kganyago made it clear that the Bank’s duty is to increase borrowing costs to tame sticky inflation — even if this causes some financial distress.
“We unfortunately have to administer particular medicine to tame inflation,” he said. “Failure to administer that medication might result in the patient having to undergo surgery or end up in intensive care.”
We unfortunately have to administer particular medicine in order to tame inflation. Failure to administer that medication might result in the patient having to undergo surgery or end up in intensive care
— Lesetja Kganyago
The other key factor that will guide the MPC in July will be its rand outlook.
While the currency has recovered well, nobody can be sure that it has hit its worst level in the cycle or that rand gains will continue.
Absa currency strategist Mike Keenan attributes the rand’s recovery partly to the recent release of better than expected local GDP, current account and manufacturing data. Less intense load-shedding, combined with signs that Operation Vulindlela is making progress on structural reforms, may also have played a part, he says.
The rand is clearly benefiting from a weaker US dollar (caused by the Fed’s pause last week, at a time when the European Central Bank, or ECB, kept hiking policy rates). There has also been a renewed appetite for South African government bonds since the beginning of June, resulting in significant foreign capital inflows into the bond market.
“Nonetheless, the fact that the rand is still trading at a significant discount to comparative currencies suggests that investors are still demanding a relatively high risk premium to compensate for South Africa’s nagging idiosyncratic risks,” says Keenan.
So, though he has become less bearish about the rand in the near term, he expects it to resume a weakening bias and to end 2023 at R18.75/$.
“We suspect that the ongoing threat of severe load-shedding, further monetary tightening from the Fed, the lingering uncertainty surrounding the outcome of the Lady R investigations, the Brics summit in August, and the Agoa [African Growth & Opportunity Act] summit in November may require a persistent event-risk premium to be priced into the exchange rate,” he says.
Local inflation has fallen sharply, creating space for the Reserve Bank to stop hiking rates — if only the rand can hang onto its recent gains
— What it means
In the second half of 2023, markets will remain fixated on the direction of interest rates globally.
“Hawkish central banks worldwide have dashed market expectations of imminent rate cuts in response to a potential economic downturn, leaving markets uncertain about the future direction of monetary policy,” explains RMB in a note.
The Fed recently paused its aggressive hiking cycle, but the majority at the Fed believe about 50bp in further rate hikes are still warranted as inflation is not yet under control.
The ECB has also left the possibility of more rate hikes open after hiking by 25bp earlier in June, citing risks from increasing wages.
The Bank of England hiked rates by an outsized 50bp last week, taking the bank rate to 5%, as annual inflation remains stubbornly above 8%.
“There’s every chance that those backing 50bp did so in the hope that doing more now may necessitate the need to do less later on and for a shorter period of time,” says Oanda senior market analyst Craig Erlam. However, with the increasing odds of the bank rate rising above 6%, he fears “it could get rather painful if inflation doesn’t improve soon”.
Central banks’ hawkish bias is undermining the consensus belief that a global economic downturn, led by the US, would curb inflation and prompt rate cuts, thereby weakening the dollar to the benefit of emerging-market assets.
Rand Merchant Bank (RMB) strategist John Cairns says markets are pricing in another 25bp hike for the Fed and the ECB at their next meetings and for global central banks generally. “So we’re not quite at the end of the cycle yet and that’s possibly going to put pressure on the Reserve Bank to do a final 25bp hike.”
RMB’s house view is that the Bank is done hiking. However, the July MPC meeting is clearly going to be a close call.
North West University Business School economist Prof Raymond Parsons urges the Bank to pause at its July meeting to assess the cumulative effect on the economy of 10 consecutive rate hikes since November 2021.
He says the Bank’s latest leading business cycle indicator, which has been pointing to an economic downturn for the past year, declined by a further 9.1% year on year in April.
“Other recent high-frequency economic data also strongly reinforce[s] the expectations of much weaker business conditions prevailing in the second half of 2023, with downside risks,” he adds, noting that most economists’ 2023 growth forecasts for South Africa are close to zero.
Khan expects the market’s focus to shift quickly to how soon the Bank may be able to ease rates. Some MPC members have suggested that this will happen only when the 4.5% midpoint of the target is reached, and when the Bank is confident that inflation will stay there.
The FRA curve indicates that the first 25bp cut is likely only at the end of next year, but many economists think this could happen a little earlier if inflation continues to fall rapidly towards 4.5% year on year in the absence of economic growth.
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