Rand Outlook Improves after Economy Exits Recession and as Stars Align for a Further Recovery

© Comugnero Silvana, Adobe Stock

- ZAR rises after economy exits recession and Christmas comes early.

- 2018 oil price gain has unwound and outlook for USD is deteriorating.

- Which could mean more sustained relief for the South African currency.

The Rand hit a four-month high Tuesday as investors responded to figures showing the economy exiting recession in the third-quarter, and as the bond market shifted in favour of South Africa's currency. 

South African GDP rose at an annualised pace of 2.2% during the third-quarter which, more than reversing the -0.4% contraction seen in the previous period, was far ahead of the 1.6% growth markets were looking for. 

This takes the economy out of the recession it fell into at the beginning of the year and will doubtless be welcomed by the South African government, whose debt is measured by ratings agencies as a percentage of GDP. 

It will also come as a welcome development for the South African Reserve Bank (SARB), which warned in November that risks to the economic outlook are on the downside and that risks to the Rand are running high. 

"While most of the sub-sectors rebounded notably in Q3.18, the uptick in growth can also partly be attributed to low statistical base factors," says Lara Hodes, an economist at Investec Bank. "[It is] likely to strengthen our fair value estimate on USD/ZAR and reinforce recent gains de-anchoring the local unit from 13.60." 

Above: USD/ZAR rate in 2018.

The agricultural and manufacturing sectors saw output rise at high single digit rates during the recent quarter, making them the star of the South African show, although business investment fell sharply for a third consecutive quarter and international trade subtracted from GDP rather than adding to it. 

Statistics South Africa did not say why business investment fell during the recent quarter, although it's possible that companies battened down the hatches in response to the recession entered into during the previous period.

"It remains to be seen whether offshore investors will take kindly to Parliament’s likely adoption of the constitutional review committee’s report on the review of Section 25, which intends for the expropriation of land without compensation," says Nema Ramkhelawan-Bhana, an economist at Rand Merchant Bank.

Falling investment could also have been a response to events in the political arena because the three-quarter downturn began around the same time the Cyril Ramaphosa government backed an opposition motion calling for legislation to legalise the expropriation of land without compensation.

Since then efforts to enable expropriation have gathered momentum, while some analysts and economists have said that such actions could depress domestic investment and turn international investors away from the country.  

"The effects of perceived domestic political and policy uncertainty have weighed on sentiment and been a contributing factor to SA’s lacklustre economic performance. A sustained increase in economic growth is therefore partially reliant on the effective implementation of policy reforms," says Investec's Hode. 

Above: Pound-to-Rand rate in 2018.

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Oil Market to Pay South Africa an Economic Dividend

International trade became a weight around the ankles of the economy last quarter after imports, which send money out of an economy, grew faster than the exports that are needed in order for trade to lift GDP. That could have been the result of what was then a 20% 2018 increase in the price of oil, which is mostly imported into the country. 

Brent oil prices rose close to 20% during the 10 months to the beginning of November. The damage done by that price increase didn't end with the trade deficit. It also exacerbated the economic decline by lifting inflation and left the currency badly damaged because South Africans were forced to sell more Rand in order to pay higher U.S. Dollar oil prices. 

"Of continued interest is the Brent crude price, which is comfortably trading above US$62/bbl after Russia and Saudi Arabia agreed to extend the OPEC+ agreement into 2019, though no mention was made of production cuts. The market remains skittish," says Ramkhelawan-Bhana 

Since the beginning of November speculation about a possible deal between the U.S. and Saudi leadership, to manipulate prices lower following December's Organization of Petroleum Exporting Countries (OPEC) meeting, has driven the oil market from boom to bust and the Brent crude price is down -6% for 2018. 

This bust, if maintained, will pay an economic dividend to South Africa because it will lead to lower inflation, less pressure on the Rand and may help to repair the some of the damage done to the trade and current account balances.  

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Christmas to Come Early in South Africa?

The oil bust will pay South Africa a dividend, but Tuesday's events in the international bond market may eventually prove to have been tantamount to an early Christmas because of what they might mean for the U.S. interest rate outlook, or at least the market's perception of it. 

"If the US curve flattening represents more than just an oversized short position in Treasuries, and tells us something about shifting expectations about the future outlook for the US economy, then it isn't ‘good' for the dollar," says Kit Juckes, chief FX strategist at Societe Generale. 

Above: Five-year U.S. Treasury yield (red and blue) and three-year yield (red).

The yield paid to new owners of three-year U.S. treasury bonds was quoted above that paid by longer term five-year bonds for the first time since 2007 on Tuesday, making for an 'inversion' in one part of the 'yield curve' that represents returns offered to new investors in bonds of all differing durations. 

There are differences of opinion among analysts about what this means for the U.S. economy, with some saying it suggests a recession may not be far off and others saying it doesn't mean anything at all, although most agree it is a clear negative for the Dollar. 

Changes in market rates like bond yields have a powerful influence over capital flows and demand for different currencies. And price action is now signalling to investors that the longer-term outlook for U.S. yields is darkening.

Yields, or bond traders, tend to anticipate changes in Federal Reserve (Fed) monetary policy, while the Dollar and broader market always respond to both.

Investors and traders have speculated in recent weeks that the Fed may soon be forced to stop raising its interest rate for a period of time. If it does eventually do that, then both yields and the Dollar might fall more consistently, providing relief to currencies like the Rand.

The Fed has raised its cash rate eight times since the end of 2015, taking it up to 2.25%, which has put upward pressure on borrowing costs the world over but particularly in emerging market economies like South Africa. That policy and its implications have also driven the U.S. Dollar higher and emerging market currencies into the ground. 

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