South African Rand a Buy Against the Japanese Yen

A strategy note out from Morgan Stanley suggests the rand is likely to benefit against the Japanese yen over coming weeks.

• Rational for the trade is the SARB would like to see a stronger exchange rate, whereas other emerging markets would prefer to see their currencies weaker.
• “The near-term relief rally may continue – and we accordingly buy ZAR/JPY" - Calvin Tse at Morgan Stanley.

The South African rand was the top performer versus the US dollar in the emerging market complex of currencies this week in a sign of a return of confidence in the unit.

The Yellen-inspired broad emerging market rally contributed to the high-yielding ZAR’s advance, as did the Constitutional Court ruling against President Zuma, which improved confidence in the country’s governance.

A falling US dollar, rising South African inflation and subsiding political risks make the rand a target for those betting on currency markets.

The narrative around ZAR has been negative ever since the currency dived in spectacular fashion in the wake of the dismissal of finance minister Nene in December 2015.

While it is easy to get bogged down in a negative mindset it is important to remember that while domestic drivers are important to the rand it would be unwise to attribute too much emphasise here.

Rather, look global.

It is telling that of late the world’s financial system has witnessed a vast relocation of capital from low-yielding, low risk jurisdictions like the United States to higher-yielding and higher-risk emerging markets.

South Africa is one of those recipient nations.

Strategists at investment bank Morgan Stanley point out that March saw large inflows of currency into emerging markets while there was an outperformance of emerging market assets and foreign exchange.

“As long as EM growth indicators do not deteriorate from here and the Fed does not readjust its current dovish stance, EM inflows should remain supported,” say Morgan Stanley.

This week, Morgan Stanley add to their foreign exchange trading portfolio a long ZAR/JPY trade as well as short USD/MXN and USD/NOK positions.

South African Inflation is Key to This Trade

In determining which EM currencies to buy, Morgan Stanley argue it is also important to consider to what extent central banks will be willing to see their currencies appreciate.

Research suggests that where inflation is running high and above expectations is where there may be less resistance to currency appreciation, such as in parts of LatAm and the ZAR.

South African inflation is running high at an annual rate of 7% with Statistics South Africa placing much of the blame on an agriculture industry that is struggling.

“During November 2015, in the midst of South Africa’s worst drought in 23 years, Stats SA released gross domestic product figures showing three consecutive quarters of steep decline in agricultural activity,” say Stats SA.

The drought has forced South Africa to import maize to make up the shortfall.

With rand weakness driving up the prices of other imports such as wheat, concern has grown over rising food inflation.

Households that depend on grain-based products, and households already struggling to pay for food, are likely to be affected the most.

The South African Reserve Bank therefore does not have the qualms associated with a stronger currency that plagues the likes of New Zealand and Australian monetary policy makers.

Remember too that South Africa is not endowed with oil reserves and for fuel prices to stay low the country requires a strong currency.

Political Risks Fading

Strategists at Morgan Stanley say they tend to avoid betting on emerging market currencies where political risk is high.

In Peru, Turkey, and Brazil they believe that volatility will reduce the attractiveness of being long.

In some of these cases as well, risk/reward is skewed to the downside from tail scenarios.

“In the case of South Africa political risk is clearly high; however, the market has responded well to the high court’s ruling against President Zuma regarding state-financed upgrades to his house, perhaps given more confidence in the rule of law,” says Morgan Stanley’s Calvin Tse.

Questions surrounding what this means for Zuma and the ANC, and separate issues related to the Finance Ministry remain highly uncertain.

“The near-term relief rally may continue – and we accordingly buy ZAR/JPY - but these issues are worth monitoring,” says Tse.

Japanese Yen to Underperform

Given JPY’s inverse relationship to risk, as well as scope for portfolio outflows from Japan over coming weeks as the fiscal year turns (see Tactical USDJPY Rally, March 23, 2016), Tse looks for the yen to be a standout under-performer.

“We think ZAR/JPY will break above the top of recent ranges at 7.65, and target a move above 8.25 over the coming months,” says Tse.