The two big events to look out for in May — other than the possibility that Moody’s could join Fitch and S&P in downgrading SA’s credit rating — are the US Federal Reserve’s May meeting, followed at the end of the month by SA’s third monetary policy committee (MPC) meeting of the year.
First up will be the federal open market committee (FOMC) meeting on May 2-3.
In March the Fed raised rates by a further 25 bps, taking the target range to 0.75%-1%. It was only the third time since the 2008/2009 recession that the Fed had raised rates.
Most Fed officials expect the central bank to raise rates at least two more times this year.
At the time of writing in mid-April, the Fed fund futures market was pricing in only a 13% chance that the FOMC would hike its policy rate in May. The odds of a June Fed hike were almost 70%, with the likelihood of two or more hikes by the year-end at 53%.
Fed chair Janet Yellen said at the University of Michigan’s Ford School of Public Policy in April that, with the economy looking “healthy” and expected to continue growing at a moderate pace, it is time for the Fed to ease off the pedal.
“Whereas before we had our foot pressed down on the gas pedal trying to give the economy all the oomph we possibly could, now allowing the economy to kind of coast and remain on an even keel — to give it some gas but not so much that we are pressing down hard on the accelerator — that’s a better stance of monetary policy,” she said. “We want to be ahead of the curve and not behind it.”
The most recent US economic data suggests there has been some improvement in US economic activity, including in employment and business confidence.
At just 4.5%, US unemployment is at its lowest level since mid-2007. The economy has created more than 15m jobs since the financial crisis ended. On the other hand, nonfarm payrolls rose by just 98,000 jobs in March against market expectations of a gain of about 180,000. Job gains have averaged 178,000/month over the past quarter.
There has also been some increase in US inflation, with core inflation up at 2.2% y/y and headline inflation at 2.7% y/y in March, against the Fed’s goal of 2%. All of this suggests the Fed is likely to hike rates at least two more times this year, according to Stanlib chief economist Kevin Lings.
As important as whether the Fed hikes rates in May will be the evolution of its “dot plot graph” (the interest rate forecasts of individual FOMC members, which are plotted as dots on a graph).
BNP Paribas Securities’ Jeff Schultz believes the fact that the median dots remained almost unchanged at the March FOMC meeting explained financial markets’ dovish reaction to the rate hike.
However, the fact that the March dot plots indicated a little less disagreement about the appropriate policy stance that should be adopted this year could signal that confidence in the Fed’s baseline forecast is firming. If this is the case, then Schultz expects the median dots to shift in May from indicating the probability of two rate hikes this year to three.
A more aggressive rate-hiking cycle would depend on President Donald Trump providing significant further stimulus to the US economy and inflation surprising on the upside, adds Lings. “If this were to occur it would quickly raise concerns that the US economy is starting to overheat. This is certainly not the case at the moment.”
If anything, Trump’s inability to repeal Obamacare could create some uncertainty within the committee as to the extent and pace of fiscal expansion he will be able to effect this year.
On May 23-25, the SA Reserve Bank’s MPC will meet.
At its previous meeting, Bank governor Lesetja Kganya-
go noted that the inflation outlook had improved, due mainly to the further appreciation of the rand.
The significant narrowing of SA’s current account deficit had also helped, while the more positive growth outlook in advanced economies had contributed to a more favourable environment for emerging markets as a whole.
“However, recent heightened domestic political uncertainty has reversed some of these exchange rate gains,” Kganyago warned. “The risk of further rand weakening overshadows the inflation outlook.”
Following President Jacob Zuma’s cabinet reshuffle in late March, S&P cut SA’s foreign currency rating to junk status and its local debt to the last notch of investment grade, with a negative outlook.
Fitch followed within days, cutting both SA’s foreign and local currency ratings to junk.
Moody’s, which has both of SA’s ratings pegged two notches above junk, placed SA on a review for a downgrade, saying it would make a decision within 90 days.
So far the rand and bond yields have proved remarkably resilient, but should S&P and Moody’s downgrade SA’s local currency rating to junk, the country’s bonds would be dropped from the World Government Bond Index (WGBI), which could trigger US$8bn-$13bn (R100bnR150bn) of forced selling by foreign investors, according to various estimates.
The resultant capital outflow would likely force the rand to fresh lows, stoking inflation and inviting higher interest rates.
In March the MPC said SA might have reached the end of the tightening cycle, but it warned that this assessment could change if the risks to the inflation outlook increased or actual inflation deteriorated.
The biggest threat to inflation is the scope for further rand weakness. The Bank is clearly worried, noting in its March MPC statement that “the rand is likely to react further to unfolding developments until a greater degree of certainty and confidence is restored”.
It added that the possibility of the rand “significantly overshooting” in the short run could not be ruled out.
The MPC also remains concerned about the stickiness of inflation expectations, noting that longer-term expectations remain anchored “uncomfortably” at the upper end of the target range. This — and the fact that forecast inflation is still set to remain elevated at above 5% for 2018 and 2019 — limits the scope for rate cuts.
Though there is a possibility that oil and electricity prices could come in under the Bank’s assumptions, overall the MPC assesses the risk to the inflation outlook to be moderately on the upside.
Schultz thinks the Bank will be careful not to downgrade its domestic growth assumptions
Recent heightened domestic political uncertainty has reversed some of these exchange rate gains
and revise its inflation forecasts up too aggressively in May in response to SA’s recent sovereign rating downgrades.
The Bank’s most recent projection is for headline inflation to average 5.9% in 2017 (previously 6.2%), falling back within the target range by the second quarter of this year (previously the fourth quarter). After that CPI is expected to remain below the upper target limit of 6% until the end of 2018.
“Undoubtedly the Bank is going to highlight the negative financial market implications of the recent credit ratings downgrade into subinvestment grade by S&P and Fitch,” says Schultz. “It is, however, unlikely to be too alarmist, noting that the currency has been more resilient than anticipated, that SA’s eligibility for key world bond indices [like the WGBI] remains intact, and that fixed income flows into SA’s domestic bond market all remain relatively well supported for the moment.”
The rand and inflation outlook have probably not deteriorated enough for the Bank to warn that rate hikes are back on the table but, given SA’s fraught political situation, it might well resuscitate its previous warning that “the bar for monetary easing remains high”.
The March Reuters consensus forecast is for the repo rate to be held steady at 7% this year.