South African Rand Seen Running Out of Steam and into Reform Challenges 

Above: Tito Mboweni. File image © Government of South Africa, reproduced under CC licensing

- ZAR breaks 14.0 level amid hopes of Fed rate cuts, reforms.

- ING eyes further ZAR gains in short-term, risks further out.

- But RMB and Morgan Stanley says ZAR running out of steam.

- Morgan Stanley cuts forecasts for ZAR as rating risk mounts.

The Rand extended a stellar run of gains Friday and many tip it to rise even further in the weeks ahead but analysts at Rand Merchant Bank (RMB) and Morgan Stanley have warned that South Africa's currency risks running out of steam and head-on into the difficult demands of the economic reform process 

South Africa's currency has been a significant beneficiary of an apparent decision by the Federal Reserve (Fed) to indulge market concerns about the U.S. economic outlook by cutting interest rates in order to head of an anticipated slowdown in growth. 

The Fed's repeated signals that it intends to cut rates as soon as the end of July mean that U.S. assets are no longer quite so appealing to international investors, offering respite from the interest rate pressures that have sucked capital out of emerging markets and hurt the Rand in the last 18 months. 

"The Rand, already strengthened by expectations of easier global financial conditions following the Fed statement on Wednesday, outperformed its EM peers, recording 0.23% in daily spot returns despite a better-than-anticipated US CPI print and a resurfacing of trade tensions expressed through yet another Trump tweet," says Nema Ramkhelawan-Bhana at Rand Merchant Bank. 

Above: South African 10-year government bond yield, alongside U.S. equivalent (orange line, left axis).

It's not only expectations of respite from strong Dollar and high U.S. interest rates that have helped the Rand in recent days as domestic news-flow has also supported the South African unit. Thursday saw speculation of an imminent easing in funding pressures for state power utility Eskom lift the currency too. 

Public Investment Corporation, South Africa's government pension fund and Eskom's largest bondholder, was said to be mulling over a debt-for-equity swap that would improve the condition of the ailing utility's balance sheet and reduce risks to the nation's top credit rating in the process. 

Eskom is threatening South Africa's crucial 'investment grade' credit rating assigned by Moody's because the taxpayer is on the hook for R350bn of its debt that is guaranteed by the government. The cash-strapped utility is at risk of failing after years of mismanagement and underinvestment in its asset base. 

"ZAR has been the best emerging market performer of the week, buoyed by: i) dovish Fed and soft dollar, ii) CNH stability and iii) news yesterday that Eskom’s biggest bondholder plans a debt-equity swap. Under 13.85, USD/ZAR could briefly trade to 13.50 (a SARB rate cut next week might help the ZAR via bond inflows), but ZAR gains could quickly evaporate if trade tensions re-escalate later this summer," says Chris Turner, head of FX strategy at ING. 

Above: South African Rand performance Vs G10 this month. Source: Pound Sterling Live. 

The USD/ZAR rate was quoted 0.10% lower at 13.94 Friday band is now down 2.8% for 2019, denoting weakness of the U.S. Dollar as well as recent strength in the Rand. The Pound-to-Rand rate was 0.06% lower Friday but has fallen 4.3% this year, with the Brexit saga continuing to haunt the British currency. 

The prospect of the Fed cutting its interest rate at the end of this month and again in September, which is what the overnight-index-swap market was implying on Friday, could offer continued support to the Rand in the short term but RMB has warned clients the South African unit risks running out of steam. 

"The market will be hard-pressed to keep the local unit trading below USD/ZAR14.00 and SAGB yields flatter, if risk sentiment peters out on the back of trade concerns and momentum is lost on Eskom’s turnaround plan," says Ramkhelawan-Bhana, in a research note posted Friday. 

Ramkhelawan-Bhana is not alone in fearing the Rand could soon lose momentum because the analyst team at Morgan Stanley also cut their year-end forecasts for the currency this week, although even they say the South African unit can still outperform for a while longer in the short-term. 

"With significant market attention focused on the path of US monetary policy,and whether the Fed will cut by 25bp or 50bp, we think there is a decent chance ZAR will rally in the short term as the USD declines," writes Hans Redeker, Morgan Stanley's head of FX strategy, in a recent missive to clients. 

Above: USD/ZAR follows South African 10-year bond yield. Falling yield denotes selling of SA bonds.

Despite the upbeat outlook for the South African currency in the short-term, the challenges likely to be faced by the Rand in the Autumn months are significant and not least of all because November will bring the next Moody's decision on the nation's credit rating. 

"The growth recovery in South Africa has been disappointing, while the scale of the reform challenges facing the South African government is considerable," Redeker says. 
"Our economics team sees a significantly wider fiscal deficit relative to that forecast by the South African Treasury and also Moody's,and a very subdued growth forecast of 0.4% in 2019 and just 1.3% in 2020."

South Africa's government is under pressure from Moody's to reduce both its budget deficit as well as national debt pile, but the economy shrank in the first quarter and the outlook for it in the year ahead is highly uncertain. If the economy continues to shrink it will risk automatically lifting the debt-to-GDP ratio as well as necessitating higher government spending on things like welfare, which could prove too much for Moody's to tolerate.

Losing the Moody's rating would mean many international investors, particular those that benchmark to the Citi World Government Bond index, are automatically forced into selling their South African government bonds. This would force government funding costs higher by lifting bond yields and drive the Rand into the ground in the process as investors seek to swap capital back into their domestic currencies.

The above graph provides an indication of where the USD/ZAR rate might go if the 10-year yield is forced substantially higher because of foreigners selling their South African government bonds. The risk of a final quarter downgrade of the credit rating to 'junk' status is one of the reasons behind the Morgan Stanley forecast cuts. 

"We think this justifies an adjustment to our USDZAR profile for the remainder of 2019. We make two adjustments.First, we shift our Q3 forecast to 13.6 (from 14.0) and second, we shift our Q4 forecast to 14.2 (from 13.2)," Redeker says. 

Morgan Stanley forecasts the Pound-to-Rand rate will rise to 18.03 by year-end, from 17.50 on Friday.

Above: Pound-to-Rand rate at weekly intervals, alongside SA 10-year yield (purple line, left axis).

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