MPC and the currency pendulum

FX

We expect that the SARB will stay on hold at its MPC meeting this week. The Committee’s decision will be announced on Thursday. The market has grown more concerned over recent days regarding the outcome, owing with little doubt to weakness in the USDZAR exchange rate. However, using the difference between the 1X4 FRA and three-month JIBAR as of Friday’s close, the market would appear to be discounting a less than 50.0% chance of a 25 bps hike. The median consensus view for Thursday’s outcome is that the Bank will stand still. Of the 17 analysts covered in the Bloomberg poll by Friday, five were expecting a 25 bps hike in the repo rate to 6.0%; 12 were expecting the repo rate to stay at 5.75%. The outcome is by no means a sure bet, especially given the “fine line” the Bank believes it is treading between its inflation objective and deepening growth concerns. Whether or not the Bank hikes, we expect that the tone of the Statement will remain very hawkish, leaving the risk of further monetary tightening firmly in play, and thereby limiting the extent of any rally in local interest rate markets. We still think that the Bank will deem it necessary to take one more pro-cyclical tightening step of 25 bps within the next few meetings, but that it could then stay on hold for a period far longer than the market expects.

There are three key risks to our baseline call regarding this week’s MPC outcome. The first is what comes out of this week’s FOMC meeting in the US, which concludes on Wednesday. We think that this is the main reason why EM currencies have been on the back-foot over the past few days. The market will be looking for any inflexions in the tone of the FOMC statement, in the summary of the Committee’s economic projections, and in Fed Chair Yellen’s rhetoric in the press conference following the conclusion of the policy meeting. The market will pay a great deal of attention to currently time dependent forward guidance, which remains for the target rate to be kept where it is for a “considerable time” following the conclusion of QE. We think that the risk of an adverse shock here has perhaps diminished by the extent to which the market is already nervous running into the outcome. The second risk would be a material depreciation of the rand, which depends to a significant extent on what emerges from the FOMC meeting; if we are correct regarding the FOMC outcome, the rand could enjoy a relief rally, against the dollar in particular. The third would be a material upside surprise in the CPI inflation numbers for August, which will be released on Wednesday. Our headline CPI forecast sits below consensus (see further comment below), which is among the reasons that we expect that the Bank will stay on hold.

With rand having broken through the key 11.0000 resistance marks, plus a few more north of that, we would acknowledge that there is a now a crack in the ‘technical’ ceiling, which increases the risk that the rand could move closer towards its January high of 11.390. However, it is not clear how much more concerned the SARB about the exchange rate than it was in July, to the extent that the trade-weighted exchange rate has lost less ground. The rand has depreciated by 3.1% against the dollar, but by only 1.8% on a trade-weighted basis since the start of September. Since the day before the July MPC announcement, the rand has lost 3.0% against the US dollar, but has lost only 0.5% in trade-weighted terms. Furthermore, international oil prices have plummeted, and soft commodity prices (using The Economist food price index as a proxy) are also moderately down in dollar terms versus the time of the last MPC meeting following a dramatic fall commencing in the late stages of April.

The Bank repeated in July that its decisions would remain “highly data dependent”. We would take this to mean highly inflation data dependent in particular. We have seen one CPI print since the last MPC meeting. The headline measure came in at 6.2%, down versus the highest point thus far in the cycle of 6.6% in May and June, and below the Bloomberg median consensus forecast of 6.3%. However, core CPI inflation continued its upward march, rising to 5.7% in July from 5.6% in June and matching consensus expectations. It is not clear whether these results would – combined - have materially surprised the SARB. August CPI numbers are released during this week’s MPC meeting (on Wednesday). The median call is for a dip to 6.2% in the headline measure and a steady reading of 5.7% in core inflation. SGBS economist Kim Silberman is more optimistic; she expects that the headline measure could dip to 6.1%, owing to a view regarding food prices that is likely more sanguine than consensus regarding food prices pressures. The headline result should also be pulled lower by a sizeable fuel price cut at the start of August but, given the transparency here, the market has likely fully factored this in. To the extent that the relative optimism in our view on the headline CPI is likely explained by differences pertaining to food prices, we do not expect a surprise in the outcome for core. Needless to say, Wednesday’s CPI outcome will have a material bearing on the probabilities surrounding Wednesday’s outcome – in particular, whether or not it suggests that the peak in headline inflation is done or is still to come.

The approach to this week’s FOMC meeting, taking place 16 to 17 September, has been largely responsible for the general risk-off sentiment we’ve seen over the past week, which kept emerging market currencies on the back foot against the dollar. The Fed is widely expected to pare back its asset purchases by another USD10 billion, keeping it on track to end the programme by the October FOMC meeting with a final USD15 billion reduction. However, the market is undoubtedly more interested in, and more anxious about, whether the Committee will decide to alter its forward guidance this week, as well as if Fed Chair Yellen will provide more details on the Committee’s plans regarding policy normalisation. Committee participants will also be updating their economic projections this week – a summary of these projections will accompany the release of the FOMC Statement. A notably hawkish change in the Fed’s perceived stance on Wednesday would most likely intensify the pressure on EM currencies. But Steve Barrow (our G10 FIC Strategist) is not sold on the idea that the Fed will do this. In fact, he still leans more to the view that the Fed will conduct the transition to tougher language and higher rates in a way that does not cause significant damage to global markets. He does acknowledge that this is going to be a bit of a minefield for the Fed, and one wrong step could clearly cost EM currencies dearly. There might be the odd miss-steps, but he does not expect a repeat of the problems that global markets had last year as the Fed began to talk about tapering in May.

It is difficult to predict whether the Committee will already be able to reach agreement on any new wording although, given that a press conference follows this week’s meeting, it does offer Yellen the opportunity to explain that any change in the language of the Statement does not necessarily mean that “liftoff” would be occurring sooner than the Committee previously anticipated. If the consensus decides to hold off on changing the “considerable time” reference, it will be interesting to see if more Committee members choose to dissent. Of particular interest for markets will be FOMC participants’ projections for the fed funds rate – that is, the “dot plots”. As of the June meeting, the median consensus among participants put the end-2015 fed funds rate at 1.00%, unchanged from the consensus at the March meeting. In June, there was a marginal upward drift in end-2016 predictions for the fed fund rate, with the consensus at 2.50%, up from 2.25% at the March meeting. However, this was offset by a drop in participants’ consensus view of the longer-run fed funds rate, put at 3.75% in June from a long-standing 4.00% in March.

August data for China released over the weekend was underwhelming, confirming expectations that Q3:14 will be more difficult than the previous quarter. Retail sales growth moderated from 12.2% y/y in July to 11.9% y/y in August. This is the lowest growth rate since 2006. Fixed asset investment growth from January to August dropped from 17.0% y/y in July to 16.5% y/y in August, coming in at CNY30.6tr so far this year. That expansion is materially lower than the market had expected and the lowest growth rate since December 2002. The deceleration in the growth rate in August was uncharacteristically large. On a year-on-year basis, the picture is even worse: on this score, fixed asset investment growth actually first slipped from 17.5% y/y in June to 15.6% y/y in July, and now to just 13.3% y/y in August. In the first eight months of this year, real estate investment has been a critical soft spot, slowing from 13.8% y/y in July to 13.2 y/y in August, making up CNY5.9 trillion. Investment in residential property, which accounts for nearly 70.0% of the total, slipped by nearly one pp to 12.4% y/y. This is no surprise: housing sales in China in the first eight months of the year fell 10.9% to CNY3.43 trillion. Quite simply, property developers continue to struggle with weak sales, large inventories and tight credit conditions. Industrial production growth slipped considerably, from 9.2% y/y in July to 6.9% y/y in August. The growth rate is the slowest in over six years. Most worrying, China’s economic fragilities have intensified. In July, only six of 14 sectors experienced a slowdown in y/y growth of industrial production in July; in August, all of the sectors dipped (by an average of 2 pps). The weak economic data shows that the impact from the government’s targeted stimulus policies, enacted throughout Q2:14, has been confined to narrow areas of the economy and has dissipated.

The rand depreciated against the US dollar on Friday for the fifth consecutive day, closing at USDZAR11.02, compared with Thursday’s close of USDZAR10.97, on the back of a continued risk-off bias in global financial markets. The rand’s depreciation against the greenback occurred into a mixed performance from the dollar against the major crosses, and weakness across the majority of the commodity and EM currencies we monitor for purposes of this report. The dollar weakened against the euro and the pound, while strengthening against the yen. The rand depreciated against all of the major crosses, with the biggest move seen against the euro (0.8%). The rand took up middle ground among commodity currencies, beating the CAD and AUD. The only commodity currency that did not depreciate was the NOK. In the EM currencies category, the rand was placed fourth to last, ahead of the RUB, TRY and BRL. All but three EM currencies – namely, the INR, HUF and IDR depreciated. The rand traded between a low of USDZAR10.9521 and a high of USDZAR11.0305. Support from where the rand currently sits (at time of writing: 11.0500/11.0500) sits at 10.9600, 10.8500, 10.7650, 10.6850 and 10.6300. The next resistance levels sit at 11.0700, 11.1200, 11.1800 and then 11.2500.

Turning to commodity prices, Brent by 1.0%, and gold and copper by 0.9%. Platinum meanwhile edged up by 0.1%. The ALSI was close to flat, while the EM MSCI dipped by 0.4%. The EMBI spread compressed by 1 bp while SA’s 5yr CDS spread widened by 3.3 bps. The CBOE VIX index, a volatility proxy for global risk appetite/aversion, rose 4.0%.

Non-residents were meagre net buyers of local equities (ZAR86 million) and were meaningful net sellers of local bonds (-ZAR755 million). Selling of bonds moderated after aggressive offloading seen over the previous three days. Selling of bonds was seen in the 3-7 (-ZAR498 million), 12+ (-ZAR355 million) and 1-3 (-ZAR34 million) year segments. Buying of bonds was seen in the 7-12 (ZAR131 million) year segment. Bond yields rose by between 4 bps (R186 and R214) and 6 bps (R208). The 3x6, 6x9 and 12x15 FRAs rose by 2 bps, 5 bps and 10 bps, respectively, into deteriorating expectations for local monetary policy, driven most likely by concerns about the inflation risks posed by a depreciating exchange rate.

FI

With the currency having weakened above 11.00 against the US dollar and stayed there in early morning trade, bonds are likely to be opening weaker this morning. A big week with the FOMC on Wednesday and local MPC on Thursday and USDZAR above 11.00 is likely to make some people quite nervous. However, the R157 constituent coupons are due to be paid today, along with the R009 cash redemption, which will return some cash to the market.

There was quite a bit of Eskom news over the weekend. Business Day is reporting this morning that Eskom will not be involved as the owner of any new nuclear energy build, due to the company's financial position. Instead, Eskom will have to buy the power from the owner of the station (suggesting some level of IPP). Cabinet has also reportedly approved a funding solution for the SOE. In particular, government would support Eskom's application for tariff adjustments, in line with regulatory processes. As Eskom has said they will not be reopening the tariff application process, this suggests a yearly use of the clawback mechanism, which does not require the tariff process to be reopened. Eskom would also be allowed to issue approximately an additional ZAR50bn over the MYPD3 period, supported by government's guarantee facility. Most interestingly, reference is made to funding being provided by leveraging non-strategic state assets to strengthen the utility's balance sheet. Details would be provided by the Finance Minister, possibly at the upcoming MTBPS.

Moody’s has released commentary on SA’s current account – “South Africa’ worsening current account deficit is credit negative”. The agency states that the recent Q2 print of -6.2% of GDP was “greater than we had anticipated, even though we had expected a negative effect from platinum and manufacturing sector strikes”. The agency remains concerned that SA is vulnerable to investor sentiment because of the reliance on portfolio inflows to finance the current account. The rating agency also notes that with inflation above 6.0% and outside the target band, “a further weakening of the rand would likely have a more severe pass-through effect on inflation than the rand depreciation of 2013 and early 2014”. Such currency weakness could push the SARB to “institute additional interest rate hikes, further dampening economy activity”. Moody’s rates South Africa Baa1 with a negative outlook, on both its local and foreign currency debt ratings. The MTBPS on 22 October, as well as any Eskom announcement then, is likely to be key to any further rating moves from agencies.

Friday’s turnover was recorded at ZAR17.4bn in nominal bonds and ZAR2.8bn in inflation-linked bonds. The R186 accounted for 49% of nominal turnover and the R209 accounted for 11%. Bonds weakened, with the R204 moving 4 bps weaker and R186 moving 4.5 bps weaker. The curve bear flattened slightly with the R186/R203 spread now trading at 122.5 bps. FRAs followed the weaker currency, moving quite a bit higher. Our FI weekly “Jibar, the repo rate and FRAs “, released on Friday discusses what is being priced in by the market.

Offshore investors were recorded as net sellers of –ZAR755m on Friday, with the R186 sold particularly hard for –ZAR1.4bn. There was also aggressive selling of the R203 (-ZAR316m), while the R213 (+ZAR382m), R2048 (+ZAR357m) R209 (+ZAR198m) and R2044 (+ZAR155m) saw decent buying. Over the week, offshore investors were recorded as net sellers of over ZAR7bn.

Friday’s ILB ILB auction of the I2025, I2038 and I2050 recorded decent bids, following low demand at the previous Friday’s offering, when less than ZAR800m was raised. However, pricing was weak this Friday though, compared with Thursday’s closing MTM levels. Total bids improved to ZAR1.06bn for an auction bid/cover ratio of 1.3x, compared with the prior week’s ZAR710m. Market participation remained low, with only 14 participants (13 participants the previous week). The I2038 attracted the majority of investor interest, with 49% of the auction bids going to the bond, while the I2050 received 31% of the bids, and the I2025, the remaining 20%.

US Treasuries moved higher and the curve steeper on Friday, prior to this week’s FOMC. 10yr is now trading at 2.61%. EM bonds weakened on Friday, with average moves of +6.8 bps and +9.9 bps in the 5yr and 10yr space respectively. Russia, Thailand and India had the strongest bond markets, while Turkey and Hungary had the weakest 5yr bonds and Poland and Brazil the weakest 10yr bonds. South Africa had a middle of the pack performance in both tenors.