South African Rand Reacts to SARB Rate Cut, see Currency as "Overvalued"

- SARB cuts South African interest rate from 6.75% to 6.50%.

- Rand weakens, eyeing comments on currency and future rate moves.

- Strategists cautious, some bearish, on Rand citing 11% overvaluation.

© Kasto, Adobe Images

South Africa's Rand weakened into month-end after the South African Reserve Bank announced its first interest rate cut for nearly a year and expressed concerns that South Africa's currency is now "somewhat overvalued" following six months of gains.

The South African Reserve Bank reduced the official cash rate by 25 basis points to 6.50% Wednesday in a move that, while widely expected by the market, is seen by some as marking the beginning of a steady cycle of monetary easing. 

The decision came after four members of the Monetary Policy Committee voted to reduce interest rates while three members voted to hold.

Policymakers upgraded their forecast for GDP growth in 2018 to 1.7%, from 1.4% previously, although projections for inflation and growth in 2019 were tweaked lower. The SARB now predicts 2019 consumer price inflation of 4.9%, down from the 5.1% increase predicted in January, while 2019 growth is now seen at 1.5% as opposed to the 1.6% penciled in previously. These latter changes appeared to have been the basis for the rate cut Wednesday.

Governor Lsetja Kganyago also told reporters the South African Reserve Bank's model suggests the Rand is "somewhat overvalued" and that further gains for the currency will probably be limited. This concurs with the verdict of the vast majority of analysts, many of whom are advising caution on the Rand, while others are turning outright bearish.

The view is shared by institutional analysts with Chris Turner at ING Bank N.V. saying he estimates that the ZAR is already 11% over-valued on our medium term models. While we see the merits in holding ZAR on the back of a bond play on the new SARB easing cycle (only 60bp of easing looks priced over the next year), a largish current deficit (3% of GDP) & an uncertain external environment advises caution.

Anabelle Rey with Julius Baer in Switzerland says the Rand "has become rather expensive," and that "the high hopes around the end of Zuma era are now essentially priced in".

The USD/ZAR rate was quoted 0.95% higher at 11.75 following the SARB announcement Wednesday, after the Rand extended an earlier loss, while the Pound-to-Rand rate was 0.49% higher at 16.59.

"The Rand’s weakening response was expected as the rate cut reduces the carry returns. All the local factors: politics, ratings, rate decisions are now in the price, and we revert back to truly tracking global sentiment unless local economic growth surprises significantly to the upside," says Chris Cairns with Rand Merchant Bank. 

Cairns does however not see the SARB as necessarily embarking on a path of interest rate cuts at this juncture, a view that could put some downside protection underneath the South African currency.

"The SARB delivered the last star in alignment by cutting rates by 25bp, citing improved an inflation outlook because of the stronger rand, the consumption-dampening second-round impact of tighter fiscal policy and reduced risks. However, without any ambiguity, the bank reiterated its desire to push inflation expectations down and towards the 4.5% mid-point, which suggests to us that there is little room for further rate cuts," says Cairns.

However, RMB maintain a view that the cutting cycle has not yet ended especially given that the growth forecast has been upgraded to 1.7% in 2018, although the 2019 forecast has been trimmed down by a tenth, to 1.5%.

Lower interest rates can be expected to weaken the Rand because the currency derives much of its support from rates that are, relative to those in the developed world, very high.  

Wednesday’s interest rate announcement comes hard on the heels of a Moody’s decision last Friday to leave South Africa’s local currency sovereign debt rating unchanged at Baa3 and to upgrade the outlook on the rating from negative to stable.

The agency had threatened to cut the rating back in November 2017, citing a rising budget deficit, poor governance at debt-laden state-owned-enterprises and the then-government's apparent lack of impetus to address either of these issues.

The improving backdrop has some analysts believing the ZAR has more gains to offer in the longer-term.

“The ZAR rally, and in the wake, of the Moody's review (3% vs USD in 5 days) has left ZAR with little potential to rally any further in the short-term. We continue to like short USDZAR positions for a longer-term investment horizon, but think that the pair should fluctuate around 11.70 now and until the end of Q2,” says Cristian Maggio, head of emerging markets strategy at TD Securities. 

Moody’s rating decision removed a significant source of risk to the South African economy as a downgrade to “junk status” will have forced large numbers of international bond investors to dump their South African holdings, leading to higher borrowing costs and a steep fall in the currency. Traders were well prepared for the reprieve and have now turned their attention back to South African economic fundamentals and monetary policy.

“At 4% inflation in February was in the lower half of the SARB’s target corridor of 3-6%. It is likely to support the Rand on a sustainable level that Moody’s raised the rating outlook from negative to stable on Friday, thus reducing the inflation risks on that front significantly,” says Elisabeth Andreae, an analyst at Commerzbank. “As a result the central bank might use the favourable environment to cut interest rates and support the economic recovery as it had done in the summer of 2017.”

The Rand has risen strongly against all of its international rivals since the final quarter of 2017, including by 13% against the Dollar and by 9% against the Pound, as investors responded to a changing of the guard in South African politics and signs that reform was in air. Many correctly anticipated that this would utlimately lead to the country retaining its investment grade credit rating. 

The December election of now-President Cyril Rampahosa to lead the African National Congress was the initial catalyst for a Rand turnaround while the resignation of former President Jacob Zuma and subsequent February budget plan to raise taxes and reduce the budget deficit over coming years were seen sealing the deal on the March decision by Moody's to maintain South Africa's investment grade credit rating.

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