South African Rand Hammered by U.S. Treasury Yield Surge

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- ZAR suffers as U.S. yields surge on Powell comments. 

- But Ramaphosa's stimulus, and the SARB, could aid a recovery.

- USD/ZAR forecast to fall before year-end, but GBP/ZAR to rise. 

The South African Rand was sent sharply lower on Thursday, October 04 as investors reacted to a sharp rise in U.S. government bond yields.

The Rand was joined by other emerging market currencies and international stock markets in a significant sell-off that was a global phenomenon.

U.S. Treasury yields have soared to their highest level since 2011, breaching 3.19% on the back of growing optimism about U.S. economic prospects and upbeat comments from Federal Reserve Chairman Jerome Powell.

Rising yields on U.S. Treasuries can be a draw for international investors as well as traders, who use relative differences in bond yields in order to value currencies.  

"Suddenly the U.S. stocks trading at all time highs are looking potentially slightly overpriced and more of a risky asset than the relatively risk-free government papers," says Fiona Cincotta, Senior Market analyst at City Index.

The Rand tends to suffer in this kind of environment because it drives international capital out of South Africa, which is considered a riskier investment destination than the U.S. Treasury market.

The Pound-to-Rand exchange rate is quoted 2.45% higher at 19.40 at the time of writing, its highest level since September 19. The U.S. Dollar-to-Rand exchange rate is quoted at 14.92, 2.0% higher.

Triggering the move in U.S. yields were comments from Fed chairman Jerome Powell, who told an audience at The Atlantic Festival that U.S. interest rates could go beyond the so-called "neutral" level in coming years.

Markets, taking the comments to mean U.S. rates may move higher than previously thought, drove the 10-year U.S. Treasury yield to a seven-year high above 3.2% and returned a fresh bid for the Dollar.

That forced up local currency borrowing costs for the South African government, with its own 10-year yield rising to 9.19% Thursday, while servicing costs for foreign currency debt rose after the Rand shifted onto its back foot.

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Rand Can Recover Poise: MUFG

However, the Rand should soon recover its poise according to analysts at MUFG - the global investment bank - who say the South African currency is likely to finish the year at much more favourable levels. 

"President Ramaphosa's outlined plans included re-prioritizing ZAR50 billion of funds from the current budget, relaxing visa restrictions, and establishing a special infrastructure fund. In these circumstances, we expect current rand weakness to ease in the year ahead," says Derek Halpenny, European head of global markets research at MUFG. 

MUFG's call comes after South Africa slipped into recession during the second quarter of the year, with the economy contracting -0.7% in the second quarter after posting a -2.6% fall in GDP growth at the start of the year. 

President Cyril Ramaphosa has responded by putting together a stimulus programme that is the probably the best that South Africa's public finances can manage without encouraging a downgrade to the nation's credit rating. 

The plan is light on new funding given South African government finances remain under the close scrutiny of Moody's, the last agency to still rate the nation's local currency bonds as investment grade.

However, it does redirect through "re-prioritisation" around ZAR 50 billion (£2.7 billion) of existing funding that will now go toward government programmes that Ramaphosa says are more likely to boost the economy.

Halpenny and the MUFG team say this, along with a steadily more hawkish South African Reserve Bank (SARB), can help the Rand to retake some lost ground from the U.S. Dollar later this year. 

"The SARB is beginning to shift in a more hawkish policy direction. Three out of seven MPC members voted in favour of a hike at the SARB’s last policy meeting. The MPC assesses the risks to the inflation outlook to be on the “upside”," Halpenny writes, in MUFG's latest monthly review of currency markets. 

The strong U.S. Dollar, which has reversed a 4% first-quarter loss to trade with an almost 4% 2018 gain during recent months, has raised the cost of imported goods and pushed up consumer price gauges in all effected economies. The only way for these countries to counter that trend themselves has been for their central banks to raise rates.

Changes in rates, or hints of them being in the cards, are normally only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

The SARB held its interest rate at 6.5% in September but increasing numbers of economists expect it to raise rates in November and to carry on ratcheting borrowing costs higher throughout 2019 and 2020. Even with continued U.S. rate hikes, this could help stabilise the Rand but it might not do the economy many favours in the short term. 

"The SARB’s own model points towards five rate increases of 25 basis points by the end of 2020 to keep inflation in the middle of the target band. The policy trade-off is becoming more difficult for the SARB as tighter policy could further dampen the growth outlook," says Halpenny. 

Halpenny and the MUFG team forecast the USD/ZAR rate will decline to 14.40 before year-end and that it will fall further, to 13.60, during the first three quarters of 2019. 

However, they project the Pound-to-Rand rate will rise this year and next, to rising to 19.32 by year-end and 19.72 by the third quarter of 2019.

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