Rand to Remain on Back Foot while Analysts Flag 14.0 as Trigger for SARB Rate Hike

-Rand to remain on back foot in current strong-Dollar environment. 

-Analysts interest rates as potential lifeline, inflation key to outlook. 

-Fresh test of 13.75-14.0 range could be trigger for SARB rate hike.

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The Rand is set to remain on the back foot because the offshore environment remains detrimental to emerging market currencies, according to forecasts from multiple analysts, who say the South African Reserve Bank is unlikely to rescue the currency until the New Year.

South Africa's currency has been dented this year by a deteriorating economy on the home front, and a resurgent US Dollar, which emerged resurgent from the depths of a bear market during April. This has driven the Rand 9% lower against the Dollar for 2018 and 6.5% lower relative to Pound Sterling. 

The US Dollar move is bad for the Rand because 45% of South African government debt is owed to foreigners, with much of it denominated in US Dollars, which means those debts are now more expensive for the fiscally challenged South African government to service.

So far the South African Reserve Bank has sat on its hands, fearing what an emergency interest rate rise mean for its inflation target and what it might do the economy, which is stuck within a low-growth mire amid heightened political uncertainty at both the domestic and international levels. 

However, in the wake of last week's central bank meeting that saw Governor Kganyago warn of risks to its inflation forecasts, analysts are contemplating how long it will be until the South African Reserve Bank steps in. The SARB held its rate steady at 6.5% last week but warned that in future it may need to raise rates further and faster than previously thought.

"If at the coming meetings the forecasts for 2019 and 2020 are moved even higher then this could cause the SARB to actually start tightening policy. That said, this is not our central forecast, and we expect the SARB to keep rates on hold and to not start hiking until towards the end of 2019," says Paul Fage, a senior emerging market strategist at TD Securities.

South African inflation actually rose less than was expected in June, picking up from 4.4% to 4.6% when economists had looked for a 4.8% reading from the consumer price index, but the near-double-digit fall in the Rand this year has got observers as well as the central bank concerned about the prospect of a further increase. The SARB is mandated to keep inflation within a 3% to 6% target band.

Fage says the risks to his forecast are "clearly skewed" toward hikes happening sooner rather than later but that the Rand's performance over coming months will be key to whether the SARB pulls the trigger on a rate rise before or after the New Year. This is in keeping with what other analysts are saying. 

"While we think inflation likely will continue to surprise on the downside, the SARB probably will be inclined to hike 25bp should the currency come under pressure again later this year or early next year, even as a tightening cycle is not yet in the cards. While this complicates the profile of our repo rate projection, we see almost even risks of a hike in either November or January (depending on when USD/ZAR next nears 13.75-14.00," says Sonja Keller, an economist at J.P. Morgan. 

The 13.75-14.0 range for the USD/ZAR exchange rate is a crucial level that was struck repeatedly by the Rand during June. It has since retreated to 13.50 but should external and domestic pressures force the exchange rate higher again, the J.P Morgan team are warning that the central bank could step in with an emergency interest rate rise. 

This would alleviate pressure on the currency. Changes in interest rates, or hints of them being in the cards, are only made in response to movements in inflation but impact currencies because of the push and pull influence they have on international capital flows and their allure for short-term speculators.

"The ZAR remains more vulnerable than other emerging market currencies, not least because of South Africa’s widening current account and fiscal deficits. Moreover, we do not believe that the central bank will hike rates in 2018. We expect the rand to trade at USD/ZAR 13.9 in three months," chimes Annabelle Rey, a foreign exchange analyst with the Swiss bank Julius Baer, in a note last week.

However, the challenge for the SARB is making a choice between two evils, requiring it to weigh the risks of currency depreciation against the economic damage that might follow a rate rise. South African GDP growth collapsed in the first quarter, with the economy shrinking at an annualised pace of 2.2% when markets had expected only a 0.5% contraction. This left South African economic growth at just 0.8% for the year.

"Recent data have started to pick up relative to the weakness in the economy earlier in the year, which should relieve some of the concerns. Outward FDI has weakened ZAR in the past few years due to the lack of confidence domestically. The news about new FDI from Saudi and UAE should help reverse some of the trend," says Gek Teng Khoo, an FX strategist Morgan Stanley. "While we think ZAR could weaken against USD, it should outperform its EM peers."

The USD/ZAR rate was quoted 0.87% higher at 13.50 Monday while the Pound-to-Rand rate was 1.02% higher at 17.74.

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