Souring Rand Outlook Causes Central Bank's 'Bond Fire of the Vanities'

Bond traders were disappointed after the South African Reserve Bank (SARB) decided not to cut interest rates on Thursday.

Bonds move inversely to interest rates tending to rise when inflation expectations fall as their value is less likely to be eroded over time.

But the decision by the SARB to keep rates on hold at 6.75% meant bond trader’s positions lost ground.

The decision came as a surprise to market analysts, whose consensus expectation had been for a cut due to recent poor data and a variable inflation outlook – a view reflected in ING's Strategist Petr Krpata’s response:

“This was despite a pretty soft set of forecasts for activity and not a particularly worrying inflation outlook.”
Searching for reasons behind the SARB’s decision, analyst Razia Khan of bank Standard Chartered thinks the weak currency played a role.

The recent weakening of the Rand would be expected to increase inflation over time, thus reducing pressure on the SARB to cut rates.

Ancillary to this, but more frightening for investors, is the ever present ‘sword of Damocles’ threat of a credit rating downgrade which would blitz the value of their holdings overnight.

“We believe that recent South African Rand (ZAR) weakness may have magnified those risks, focusing attention on what might happen to inflation projections in the event of a local currency (LCY) rating downgrade.”

South African (SA) government debt is teetering on the edge of losing its investment grade status after two of the three major rating agencies already donwgraded it to junk; it now only remains for Moodys which has SA bonds two notches above junk to join them for the downgrade to be 'official'. 

Investment grade is the minimum requirement for inclusion in most large funds so a downgrade below that would be a water-shed moment, significantly reducing demand for SA debt.

“The threat of a downgrade to junk of South Africa’s key local currency rating remains a concern, which would prompt removal from key bond indices and probably trigger a 7-10% fall in the ZAR.”

The reason for the massive impact on the currency is the high proportion of debt held by foreign investors.

Indeed a major source of strength for the Rand has been demand for its bonds which are attractive to foreign investors seeking higher yield.

The interest repayments on SA bonds are over 7.0% which is significantly higher than anything investors can earn in the West.

“Net purchases by non-residents of South African government bonds have amounted to R(63) billion year to date. The domestic yield curve relative to other peer emerging market economies remains attractive to non-residents despite a decline in the curve across all maturities,” said the SARB in their September meeting policy statement.

This explains the curiously inverted reaction of the Rand to interest rate decisions by its central bank.

Normally the currency would be expected to fall as a result of a cut in interest rates but in the case of the Rand markets were expecting a rise in the Rand in such a scenario – at least that was the consensus prior the meeting.

Strangely the market was wrong about this too - as the Rand followed the conventional path of rising in the wake of the Bank’s decision not to cut rates.

Regardless of the risks of a rating downgrade the Rand may be at risk from other more subtle forces.

The recent obtuse insistence on sticking to its tightening cycle demonstrated by the Federal Reserve combined with signs from Europe that they too are rounding out of their loose policy cycle and entering the early stages of tightening could be laying the foundations for a depreciation in the Rand.

The current high demand from foreign investors for the Rand is motivated partly from a lack of alternatives, yet with western central banks now moving towards increasing their own interest rates, which will push up yields on their own bonds there may be safer alternatives closer to home.

And it may be this which lay behind Lesetja Kganyago’s decision to side with the doves in his committee rather than the hawks when it came to him casting his deciding vote – he foresaw the wider global policy backdrop changing.

If this is the case then Standard Chartered may be being a little hasty in predicting a November cut:

“Nonetheless, we still believe that the outlook favours further easing. We maintain our forecasts for rate cuts of 25bps each at the November and January SARB MPC meetings.”

And a key event to watch in the run up to the meeting is the Medium-Term Budget on October 25, which will provide an update on South Africa’s fiscal performance and therefore feed into judgements about the likelihood of a downgrade.

If the country’s finances prove weaker than expected the risk of a downgrade will overshadow the central banks desire to cut rates regardless of the inflation outlook, concludes Standard Chartered's Khan.