South African Rand Rally is Overdone says Strategist as Ratings News "Remains Dire"

The Rand has risen by 5% despite a ratings downgrade last week - what could be propelling it higher and will it last?

The Rand rose sharply against the Euro, Pound and US Dollar in the wake of last week's negative credit rating assessments; a reaction that has surprised many watching the market. 

On Friday, Standard & Poors downgraded South Africa's rand-denominated debt to sub-investment grade while Moody's warned a downgrade could be imminent. Both said South Africa's economy isn't growing quickly enough to justify its government's current spending plans.

For the Rand the implications are understandably negative as a downgrade means investors are much less inclined to lend South Africa money, leading to a fall in demand for the currency. 

It also implies large outflows of money as foreign investors might lose confidence and pull-out of their investments, further weakening the currency.

Yet oddly enough it wasn't the end of the world - the Rand moved up and down on the day but not by very much. Then, even more surprising was how it managed to come right back and strengthen by 5% against the Dollar over Monday and Tuesday.

"Some of the moves, notable at the start of the rally and again on Monday, could be partially justified by the shifts in global markets but, all told, the rand has gained around 5% versus other risk currencies — an extraordinary move!," says John Cairns, a strategist at Rand Merchant Bank.

A part of the reason is that things could have been a lot worse: yes Standard and Poors (S&P) downgraded South Africa to below investment grade status, or 'junk' as it is called, but there was a silver lining in that Moody's, the largest credit rating agency in the world, did not downgrade SA, and kept it just above the very bottom of investment-grade.

"The gains imply that the rand is now not only stronger than where it was before the downgrade but also even stronger than before the October budget," adds Cairns.

With Moody's keeping South Africa at investment grade for the timebeing the currency market could be assuming an all-out meltdown will be averted - but this is a risky bet.

"This move is not being driven by foreign real money investors. The numbers for yesterday showed foreigners dumped almost R2bn of bonds. This should be taken as a huge warning sign: it is unusual for a strong rand rally to happen without the support of strong inflows," says Cairns.

If Moody's follows S&P and Fitch, who have already downgraded the country's bonds to junk status, once into the New Year then a nightmare scenario could become a reality. 

"Our take remains that the rand gains are overdone," says Cairns. "Ratings news also remains dire, S&P yesterday downgraded Eskom by two-notches, to B- and kept a negative outlook."

No investment grade credit fund can hold bonds that have a sub-investment grade rating. With investment grade funds accounting for the majority of bond investors out there, this means South Africa could struggle to borrow - at reasonable rates anyway - if Moody's removes its investment grade rating. 

"When Moody’s has downgraded the economic outlook in the past, more often than not it has followed the 'warning' with an actual rating downgrade," says Chiara Silvestre, an Economist with Unicredits.

Political Dimension

One explanation for the Rand having avoided a bloodbath could be changes in the political outlook, with impending leadership elections for South Africa's ruling ANC Party adding another dimension to economic considerations.

RMB's John Cairns says the main reason for the rise in the Rand is an increase in the chances that Cyril Ramaphosa will win the ANC leadership election in December.

"The market is starting to price a Ramaphosa victory. This we think is the real reason. In chatting to various fund managers in Cape Town, we have noticed a very sharp shift in views," says Cairns. "A few months ago, the general thinking was that Dr. Dlamini-Zuma was probably going to win; the thinking now is on whether the Deputy President has it sewn up." 

Experts say a Ramaphosa win would be positive for the Rand because he is campaigning on a reformist manifesto, which is more likely to embrace the sort of changes that rating agencies are looking for. 

The least positive outcome for the Rand would be a win for Dr. Dlamini-Zuma, the current President Zuma's ex-wife, as she is expected to continue the status quo.

Nevertheless Cairns peppers his commentary with caveats, qualifiers and provisos, saying that, "admittedly, no one we met seems to be willing to trade his victory but presumably there are some brave souls who are punting the view," and, "while Ramaphosa's odds have risen, he is certainly not a certain victor."

One issue is the problematic voting system, which could lead to a blurred outcome in which a Ramaphosa win might be offset by Dlamini-Zuma managing to win the role of Vice President.

"What's more, the more we think about the new voting system being put in place (voting for the top positions will be done one at a time rather than together), the more we are coming to realize that a messy outcome could be forthcoming," remarks Cairns.

The messy alluded to by Cairns would be one where Ramaphosa wins the leadership vote but is left with Dlamini-Zuma as his deputy once in office.

"Given SA's political system, where so much power is vested in the president, the market would on balance probably still gain on such an outcome, but this would not be the buffalo run that it seems to be pricing," Cairns adds.

RMB forecast a move down to 13.50 USD/ZAR on the back of a Ramaphosa victory, but see the potential for a fall below 13.00 (current market level 13.74).

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