The South African Reserve Bank found itself in a difficult position today having to adjust policy to tackle inflation driven by supply-side shocks and to shore up investor confidence following sharp depreciation in the rand and a rally in the risk premium of South African bonds.
All the while, the central bank has to avoid signalling to markets that it was either done with its hiking cycle or likely to overtighten such that a negative feedback loop would be generated. Ultimately, the Monetary Policy Committee played it safe, unanimously voting for the first time since late 2021 to hike the policy rate by 50bps to 8.25%. At first, the decision was sufficient to quell downward pressures on the rand, keeping USDZAR below the upper bound of its recent range. But as the press conference wore on and investors began to lose confidence in the SARB’s ability to walk this very fine line to improve South Africa’s economic fundamentals, USDZAR broke out to the upside to hit fresh all-time highs with a move of over 2% on the day.
SARB signals further policy tightening, although the magnitude is hard to determine in advance
Governor Kganyago stated within the press conference today that the policy rate has “only just become restrictive”, suggesting that further tightening is likely in store, especially as upside risks to the central bank’s inflation forecasts have already materialised. While the SARB did in fact upgrade its headline CPI forecast for this year and next from 6% and 4.9% to 6.2% and 5.1% respectively, these forecasts were conditioned on a USDZAR rate that was some 4% below the pre-announcement level. Now, the exchange rate is some 5.5% weaker than where the SARB had conditioned its inflation forecasts, suggesting that all else equal, headline inflation is likely to be higher. The primary driver of this is likely to be from higher food price inflation, which the SARB had already revised up from 9.9% and 4.5% in 2023 and 2024 to 10.8% and 5%, owing to a weaker rand.
USDZAR breaks out of recent range to hit fresh all-time highs. At its post-meeting high, the rand was nearly 6% weaker than the level the SARB conditioned its inflation forecasts
With the central bank estimating that the neutral rate of interest is around 2.5% in real terms, a repo rate at 8.25% and a projected year-end inflation rate of 6.2% suggests that policy is at the lower end of a conservative estimate of neutral.
This was explicitly outlined by MPC members within the press conference. By doing so, this analysis validated expectations of further rate hikes by market participants. In fact, the year-end interest rate priced into forward rate agreements rose some 4bps further above 9%.
Despite the hawkish tones from the SARB and the impact that was having on South African rates, investors remained unpersuaded to pile back into the South African rand. This is understandable given the significant idiosyncratic risks that are currently hampering growth and are likely to weigh further on South Africa’s external financing needs. While this wasn’t necessarily reflected in the SARB’s growth estimate for this year, which was revised back up from 0.2% to January’s projection of 0.3% and is in our view on the more optimistic side of the spectrum, it was reflected in the Bank’s projections for the current account. Low export growth due in part to logistical restrictions amongst other factors and deteriorating terms of trade is expected to widen South Africa’s current account deficit to beyond 3% from next year. This is only expected to deteriorate further under continued supply-side strains and further depreciation in the rand.
The difficulty the South African Reserve Bank now faces is that the market no longer has confidence in its ability to improve the country’s investment outlook or to stem pressure on the rand.
Not only is this visible in the hawkish repricing of South African market interest rates and the corresponding slide in the rand, but the surge in 1-month USDZAR risk reversals. At 3.18, options markets are now skewed the most since the onset of the pandemic towards expecting further rand weakness. In the weeks ahead, all eyes will now be on the government and its ability to alleviate the idiosyncratic pressures that face the South African economy. Namely, the pressure on the national electricity grid as seasonal electricity usage is set to soar. On that topic, markets continue to await the announcement of who will take the vacant seat at the helm of Eskom after more than three months since Andre Marinus de Ruyter mutually agreed to resign.
One-month USDZAR risk reversals are the most bullish since the onset of the pandemic in March 2020
Simon Harvey, Head of FX Analysis