Time to Protect Against a Weaker Rand as Offshore Environment Seen Auguring Losses

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Assuming South Africa avoids a downgrade from Moody’s, the Rand will be driven increasingly by expectations for South African monetary policy and offshore factors during the months ahead.

Wednesday’s budget has all but enabled South Africa to avoid a downgrade of its local currency credit rating, according to multiple strategists, but the good days may soon be behind the Rand and so current levels present a attractive opportunity for those using it to start hedging.

South Africa’s Treasury said Wednesday that it will raise an estimated ZAR 36 billion in the current year from VAT tax increases, through a 1% increase in the VAT rate, and below inflation adjustments to payroll tax brackets for workers. It will also increase sales taxes on luxury consumer items and high value real estate, while raising excise duties for alcohol and tobacco.

The combined effect of these measures is that the budget deficit is forecast to fall from an estimated 4.3% of GDP in the 2017/18 year, to 3.5% of GDP in the 2020/21 year. This is expected to see the country’s debt pile stabilize at a level equivalent to 56.2% of GDP by the end of the 2022 year, which is lower than what was expected by the market.

“Budget represents further evidence of a more reformist policy agenda, and should further reduce the risks of Moody's downgrading the local currency rating in the next 1-2m. We continue to see rates markets as the key beneficiary, and maintain our forecast for a 20-40bp tightening in the South Africa-US 10y local yield spread,” says Gyorgy Kovacs, an economist at UBS.

Moody’s put South Africa “on review for downgrade” back in November, citing a rising budget deficit, a deteriorating growth and fiscal revenue outlook, as well as the government’s poor record on economic policy. Governance of state owned enterprises was also an issue too.

A loss of investment grade status could be devastating as it would see many institutional investors forced into selling their government bonds. This would push South African borrowing costs higher and put downward pressure on the Rand once again as foreign investors flee the country.

“The tighter budget is designed to appease Moody’s which is expected to retain local South African Government Bonds on an investment grade rating later this month - thereby avoiding the large sales of SAGBs a downgrade in local ratings to junk would have caused,” says Chris Turner, global head of FX strategy at ING Group.

“South Africa’s sovereign credit default swap is back down to levels last seen in 2013 and it looks like investors like the 8% yields available in SAGBs.”

South Africa’s ten year government bond yield has fallen by 0.4% this week, to just over 8%, and is down from the 9.2% it was at on the day before now-President Cyril Ramaphosa was elected leader of the ANC back in December.

This suggests investors now perceive ownership of South African debt as a much less risky prospect than it was just a short time ago.

Accordingly premiums demanded in the credit default swaps market, which enables investors to pay part of a bond’s yield out in return for protection against a default, have fallen markedly over the same time frame.

The Rand has risen by 15.6% against the US Dollar and 11.7% against the Pound during the same period as markets bet Cyril Ramaphosa’s would bring enough economic and political reform for South Africa to keep its top rating.

“We feel fair value for USD/ZAR is somewhere in the 12.00/12.50 area and we doubt that the recent pick-up in volatility looks good for carry trade strategies. For those corporates with ZAR exposure, current USD/ZAR levels near 11.60 look a good opportunity to hedge,” says ING’s Turner.

During the months ahead, and assuming the country does avoid a downgrade when Moody’s announces its next rating decision, South Africa’s currency will be driven increasingly by expectations for South African monetary policy and international factors during the months ahead.

“We and the market liked the budget. Treasury has probably done enough to avoid the rating downgrade. Let’s see what Moody’s says, but we suspect that the risk is now mostly priced out,” says John Cairns, a currency economist at Rand Merchant Bank.

However, the outlook for monetary policy and the current international backdrop may both aughur losses ahead for the Rand, given the next move in South African rates is likely to be downward and that global interest rates are rising.

With interest rates at 6.75%, the economy suffering under a low growth environment and the risk of a downgrade receding, the South African Reserve Bank may be tempted to reduce rates during the months ahead in order to spur economic activity.

“The offshore environment remains rand-negative. Last night’s minutes showed the Fed as becoming more optimistic on the economy and more worried about inflation. Market-pricing of Fed hikes this year has not changed meaningfully, but Treasury yields have pushed upwards again, the 10-year and 30-year making new multi-year highs,” says Cairns.

“The resulting further strength in the dollar, with EUR/USD breaking below 1.23, is keeping all risk currencies under pressure.”

A stronger Dollar will always hit currencies like the Rand given the high level of Dollar denominated debt carried by emerging markets, which becomes more expensive to service.

This weakness can also be exacerbated if the Dollar is rising because of global market stress, given that in times of volatility and fear, traders would naturally bet on a fall in risk assets like the Rand.

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