South African Rand Takes Rate Cut in its Stride after Reserve Bank Neglects to Indulge Market Hopes for More

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- ZAR advances after SARB rate cut as outlook clears.

- SARB neglects to indulge market bets on more cuts.

- Gives one rate cut, forecasts hint at no further easing.

- Credit Suisse looks for more upside, sells USD/ZAR.

South Africa's Rand extended gains over the Pound and Dollar in the final session of the week as investors continued to reward the central bank's decision not to cut interest rates as much as the market had been anticipating. 

The South African Reserve Bank (SARB) cut its interest rate by 25 basis points to 6.5% Thursday, citing recent falls in inflation and a struggling economy that's in need of support. The move was in line with the economist consensus although some in the markets had been betting on close to 0.50% worth of cuts. 

"The decision has left the rand stronger as the market was priced for nearly 50bps of easing ahead of the SARB announcement. This is in line with our prior expectations. However, ZAR looks a little too rich vs our forecasts now," says Cristian Maggio, head of emerging market strategy at TD Securities. 

Governor Lesetja Kganyago said Thursday the bank's quarterly-projection-model had indicated that only one interest rate cut is necessary before the end of 2019, which aal but rules out the additional cuts that financial markets have been hoping to see.

Above: USD/ZAR rate shown at hourly intervals, alongside Pound-to-Rand rate (black line, left axis).

Changes in interest rates are normally only made in response to movements in inflation, which is sensitive to growth, but impact currencies because of the push and pull influence they have over capital flows. 

Capital flows tend to move in the direction of the most advantageous or improving returns, with a threat of lower rates normally seeing investors driven out of and deterred away from a currency. Rising rates have the opposite effect.

The SARB said Thursday that risks to the inflation outlook are "balanced" because the domestic economy is weak and wage growth is low, although the growth and inflation outlook could turn higher if advanced economies gather steam while prices could rise if the Rand weakens in response to market concerns over the nation's credit rating. 

"The market is aggressively positioned for cuts," says TD's Maggio, in his earlier note. "[Forward-rate-agreements} imply 42bps of easing; another 26bps of cuts are priced in for the 19 Sept meeting and a total of 89bps are priced in for year-end. This is approximately 40bps too much."

Above: TD Securities forecast for SARB cash rate (brown) Vs market expectations (grey).

South Africa had a rough start to the year that saw the economy contract in the first quarter. The SARB downgraded its forecast for 2019 GDP growth Thursday but still projects a pick-up in 2020 and beyond.

Analysts at Bank of America said this week that because inflation is falling and the Rand has advanced against major currencies, the high-yield returns offered to international investors by South African government bonds are rising in "real" terms. The bank says this has been supporting the Rand. 

"Real 10-year yields based on core inflation are 5%, the highest since 2011 and substantially higher than at many of the major EM peers," says Ferhan Salman at Bank of America. "The trade truce and beginning of the Fed easing cycle should help EM FX and hence the South African rand...The current ZAR rally should also offer some relief to the SARB."

Salman and the Bank of America team have tipped an ongoing positive performance for the Rand in the short-term but are looking for the USD/ZAR rate to recover some lost ground before year-end, closing 2019 at 14.2. Although they also forecast a return back down to 13.9 by the end of 2020.

Above: USD/ZAR rate shown at hourly intervals, alongside Pound-to-Rand rate (black line, left axis).

Credit Suisse has also tipped the Rand for more gains this week. The Swiss bank upgraded its short-term targets for the Rand and advocated "fading spikes" in the USD/ZAR rate Monday, which means buying dips in the Rand

"Given that markets are pricing for a cut of 18bps-20bps, a 25bps rate cut should have little impact on South African assets. We are biased in favor of fading spikes in USDZAR which could be triggered if a surprising 50bps rate cut is delivered," says Nimrod Mevorach at Credit Suisse.. 

Mevorach was unfazed Wednesday by the prospect of even a large 50 basis point cut to the SARB's cash rate. He says the SARB would be very unlikely to cut rates aggressively after that and notes the Fed is also expected to slash its own rate by a similar amount in the coming months. 

"We now find it likely that USDZAR will drop to the 13.50-13.55 area in case the broader bid for the dollar remains subdued. In such an environment the underlying downside pressures on USDZAR will likely persist, assuming that South Africa does not deliver adverse news locally.," Mevorach writes, in a note to clients. "We think it makes sense to fade spikes in USDZAR as long as this picture does not change materially."

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