South African Rand Closes In On New Lows but Sell-off May be Overdone Says Strategist

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- GBP/ZAR spot at time of writing: 23.48
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The Rand was closing in on fresh lows against the Pound and Dollar Wednesday as risk aversion returned to global markets but some analysts are saying the sell-off may now be overdone while others are tipping a recovery for the South African unit and other emerging market currencies before year-end.

South Africa's Rand saw only brief respite from the selling pressures that have wrought steep double-digit losses on it for 2020 before the mood among international investors soured again, sending risk assets including emerging market currencies tumbling. Losses were built further on Tuesday as the South African Reserve Bank (SARB) cut its cash rate by a further 100 basis points to 4.25% and snowballed Wednesday when currency traders appeared to have appetite for only the safe-haven Dollar. 

Resulting losses incited the Pound-to-Rand rate into a fresh test of the 23.57 level on Wednesday, which is also the 78.6% Fibonacci retracement of the January 2016 downtrend and the last major obstacle to the record highs struck just more than four years ago. Meanwhile, the USD/ZAR rate has extended its rally higher from 17.84, which is the 100% retracement of a similary post-2016 downtrend that has offered solid support to the exchange rate this week. 

"The ZAR has been hammered by the collapse in risk appetite seen at the beginning of the coronavirus outbreak as investors sold off riskier currencies in favour of safer assets. The ZAR actually lost about 39% of its value versus the USD between early January to April and GBP/ZAR is up 23% since the start of the year," says George Vessey, a currency strategist at Western Union. "This ZAR downtrend may be overdone now though as market participants also keep a close watch on the price of gold, which continues to climb."

Above: Pound-to-Rand rate shown at weekly intervals, with Fibonacci retracements of January 2016 downtrend marked out.

Vessey tips a rising gold price as a likely source of eventual support for the Rand, given that it's South Africa's largest export by a country mile and prices have risen handsomely as a result of increased demand for safe-havens as well as an alternative to fiat currencies. Those currencies are increasingly polymer plastics with little more than numbers in ledgers sat behind them, whereas gold has long been viewed by many as an effective store of value. 

Gold was up 13.2% for 2020 on Wednesday and trading around $1718 per ounce although some influential forecasters tip it to hit $1,800 by year-end. Goldman Sachs commodities strategists said last month they're increasingly confident the "currency of last resort" will hit $1,800 by year-end while Commerzbank technical analysts said separately in their research that once past $1,703, gold would have a clean run at $1,734, $1,796 and $1,803. 

Higher gold prices mean an improved 'terms of trade,' which refers to the ratio of export prices to import prices that is one of many important influences on the market-perceived 'fair value' of exchange rates. A stronger gold outlook might also mean a lesser trade deficit, which would imply improved supply and demand dynamics for the currency and may support to the economy at the margins given that trade deficits are by definition a net drag on gross domestic product (GDP). But price rises have done little for the Rand so far.

Above: Gold price shown at weekly intervals alongside ZAR/USD rate. 

"Part of that may simply reflect the fact that Turkey and South Africa import oil, so their terms of trade worsen when crude prices rise. And in part it may also be down to policy easing by their central banks – including government bond purchases in South Africa’s case. But the key problem for [ZAR] – and for many other EMs – is the weakness of their external balance sheets, which leaves them reliant on foreign investors," says Jonas Goltermann of Capital Economics.

Goltermann says emerging market currencies could "face further turbulence" but that they should end the year higher than current levels. He does note however, that the recovery is likely to be shallower than that seen after the financial crisis due to changes in China that are affecting the outlook for commodity prices. 

Wednesday's comments come after South Africa's central bank cut its cash rate to 4.25% and in the process reduced the 'real' benchmark rate of interest to nearly zero. South Africa had an inflation rate of 3.8% in February and the SARB has a target to deliver inflation of between 3% and 6%. The midpoint of that range is 4.5% and above the current cash rate, implying a negative real rate unless the SARB can squash price pressures at the low end of the range.

The SARB said South Africa's coronavirus 'lockdown' and other factors are expected to produce a significant -6.1% economic contraction for 2020 and that they have already driven more more than R100 billion of foreign capital out of the country, partly explaining 2020's increase in USD/ZAR.

Above: USD/ZAR rate shown at weekly intervals, with Fibonacci retracements of January 2016 downtrend marked out.

"The SARB once again confirmed yesterday that it is actively contributing to overcoming the corona crisis. Its participation in the concerted action of global central banks is likely to be positively received by the market," says Elisabeth Andreae, an analyst at Commerzbank. "It has now used up most of its ammunition if it does not want to get into negative territory with its key rate in real terms. Further rate cut scope will therefore be mainly dominated by the medium term inflation outlook and thus depend on the oil price and exchange rate related risks. However, the downside risks are likely to dominate in the rand while an end of the corona crisis in not in sight." 

Real rates, which have typically been very high in South Africa and a notable source of demand for the Rand, could also become deeply negative in the event that inflation rises and the upper target band is hit.

A 6% inflation rate and 4.25% cash rate would mean a negative real interest rate of nearly 2%, likely reducing the SARB and Rand's ability to compete directly with developed world central banks and currencies for international capital that was already flighty before the SARB's cut and which is increasingly risk averse of late. 

Technically South Africa is a 'junk' borrower following the March downgrade of its credit rating from Moody's while the U.S. government remains 'investment grade,' which means the Rand might not fare well in direct competition with the Dollar for capital unless it offers a sufficiently higher real interest rate.

Managing the risks around this could be a key concern for the SARB that limits its ability to provide further assistance to the economy as South Africa navigates its own coronavirus epidemic. Coronavirus was first detected there on March 06 and subsequently resulted in a 'lockdown' of people and economy on March 27. That draconian China-inspired response has been implemented the world over and was this week extended by South Africa until the end of April.