The South African rand sits atop the EM currency board for May, joining fellow carry currencies MXN and RUB.
We have argued in recent weeks that these currencies, which experienced dramatic portfolio outflows due to the pandemic similar in magnitude to 2008/09, were due a correction once the carry environment improved. That is exactly what has happened in May as major global economies began to scale back lockdown measures.
ZAR up over 6% in May as carry conditions improve
Increased fiscal and monetary support, combined with the relaxation of lockdown measures in major markets have improved the outlook for the global economy in the short-run, while measures taken by major central banks have led to a moderation in financial frictions and funding constraints. In conjunction, economic data seems to have bottomed out after a torrid end string of readings; most notably leading indicators suggest economic activity has returned to pre-virus levels in China while PMIs paint an improving economic climate in Europe.
With the fog dissipating over the true economic damage of the pandemic on the global economy and the financial system flush with hot money coming from quantitative easing programs in full swing, we expect the carry trade to continue benefitting high yielding currencies like ZAR.
Foreign investors begin to come back to SAGB market as risk sentiment improves, while net SAGB holdings by non-residents sits near 2016 lows
While the rand’s fortunes are somewhat limited by the domestic economic fundamentals, the return of foreign investors to the SAGB market is a welcome sign for the government. With bond issuance set to continue increasing in order to finance the widening fiscal deficit, yields on SAGBs are likely to remain favourable in the current low yielding environment.
The rand’s rally could continue, albeit to levels higher than it was trading at pre-virus to reflect the deterioration in fundamentals, should the carry environment remain supported.
However, it must be noted that risks to this outlook remain plentiful in the near-term. These aren’t just isolated to a potential second outbreak, but also pertain to rising US-China trade tensions and a further deterioration to South Africa’s economic outlook and thus debt profile.
ZAR 1-month carry once adjusted for volatility rises to early April highs as other major carry currencies also rise on subduing volatility and elevated yields
Author: Simon Harvey, FX Market Analyst