Rand Clings on to Week's Gains but Federal Reserve Now Looms Large Over Emerging World

© Pound Sterling Live

- ZAR extends week-long rally ahead of U.S. Fed announcement at 19:00.

- But Fed "dot plot" could reignite USD rally and send ZAR tumbling again.

- USD key to ZAR outlook, which is itself important for South Africa. 

The Rand extended its week-long run of gains into the Wednesday session but analysts are warning the South African currency will soon come under renewed pressure if the Federal Reserve sends a "hawkish" signal about U.S. interest rates to the market at 19:00 London time. 

South Africa's Rand has risen nearly 2.5% against the Dollar this last week in response to a retreat by the U.S. currency that provided breathing room to emerging market currencies.

China's commitment to keep the Renmimbi stable even in the face of President Donald Trump's trade war, as well as hopes of some fresh stimulus for the world's second largest economy, were decisive in helping stem an exodus from emerging markets and flows into the safe-haven Dollar. 

However, the Federal Reserve policy announcement for September now looms large over global markets and could see U.S. bond yields move higher as well as a renewed bid for the greenback. This would augur yet more losses for emerging market financial assets.

"The actual Fed decision is of little consequence, with the market pricing in an almost 100% probability of a 25bp hike. The hawkishness of the Fed’s dots plot and subtle changes to the committee’s language are of greater interest. With the 10-year US treasury yield perched at 3.10%, any upward bias in rate expectations will put it within a whisker of its cyclical high of 3.13%, reinforcing US dollar gains and exerting depreciation pressure on the rand," says Nema Ramkhelawan-Bhana, an economist at Rand Merchant Bank.

U.S. Treasury yields have the ability to influence borrowing costs the world over but particularly in emerging markets, where credit worthiness is generally lower and a large portion of sovereign debts are denominated in U.S. Dollars.

This borrowing becomes more expensive to finance as U.S. interest rates rise not only because the market demands additional compensation from the emerging world, but also due to the fact the Dollar, which must be bought in order for countries to make debt repayments, becomes more costly to buy. 

Those circumstances are almost always of concern for investors in debt-laden places like South Africa, concerns that are almost always manifested in exchange rates. 

"Rates are now back in focus. Should the Fed be more hawkish than expected, the dollar should benefit. We keep an eye on dollar strength and higher US yields, as this could keep emerging market (EM) currencies, including the rand, on the back foot," says Zaakirah Ismail, an economist at Standard Bank. "We still view the rand as cheap but it is likely to remain undervalued into the early part of next year due to domestic policy uncertainty."

The USD/ZAR rate was quoted 0.27% lower at 14.29 during the morning session Wednesday but is up 15.5% so far in 2018, while the Pound-to-Rand rate was 0.47% lower at 19.79 but has risen 12.6% this year. The USD/ZAR rate had risen as much as 20% for 2018 at one point this year.

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SARB Holds Rates but for How Long?

Debt and general financial stability concerns are being made worse by other economic forces such as the steep 15% 2018 increase in the price of oil that is stoking fears of a pickup in South African inflation. The double-digit decline in the Rand is also an aggravating factor on this front too.

Higher inflation pressures are yet to actually materialise but if they do, then the South African Reserve Bank (SARB) could be forced to raise its interest rate just as the economy is attempting to pull itself up out of recession. Rising interest rates are the last thing that any economy coping with recession needs.

South African inflation rose at an annualised pace of 4.9% during August, down from 5.1% back in July, when markets had looked for an increase to 5.2%. That is comfortably inside the 3% to 6% inflation target band of the SARB, although the central bank said last week the consumer price index is likely to reach as high as 5.9% in the second-quarter of 2019. 

The bank held its interest rate unchanged at 6.5% in September but Governor Lesetja Kganyago said previously the SARB wouldn't hesitate to act if inflation deviates "significantly away" from the midpoint of the target range. Kganyago noted last week only that it "is moving further away from the mid-point of the target range".

"The global backdrop is gradually making the SARB more hawkish," says Gabriele Foa, a cross asset strategist at Bank of America Merrill Lynch. "Our house call remains for no hikes, but a scenario in which USD/ZAR remains high and inflation expectations further deteriorate would be met with a hike into year-end."

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Stimulus: Proof is in the Pudding

Recent gains for the Rand, as well as Wednesday's Federal Reserve meeting, come hard on the heels of President Cyril Ramaphosa having unveiled a stimulus package designed to support South Africa's recession-stricken economy. 

The plan is light on new funding given South African government finances remain under the close scrutiny of Moody's, the last agency to still rate the nation's local currency bonds as investment grade.

However, it does redirect through "re-prioritisation" around ZAR 50 billion (£2.7 billion) of existing funding that will now go toward government programmes that Ramaphosa says are more likely to boost the economy. 

"The proof is in the pudding and South Africans, investors and ratings agencies alike will need tangible proof of change before buying into the rhetoric," says RMB's Ramkhelawan-Bhana.

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