The rand’s strength seems to be more a function of foreign factors than local ones
The rand has left many market participants scratching their heads over the past year: as local politics and economics deteriorate, the currency has continued to strengthen. In the second quarter of 2017 it was particularly strong, despite SA being downgraded by all three major ratings agencies during that time.
The reality is that movements in the rand have been influenced far more by global yield differentials than local politics. Political noise has provided only for short-term counter-trend movements in a generally strengthening rand environment. Whenever the flow of effluent from political leaders’ mouths abates, the rand has tended to move stronger, illustrating that something much bigger than political noise has been the major driver behind the rand’s strength.
The answer to what that may be is found in two words: “carry trade”. This refers to borrowing money in developed markets at very low interest rates, and investing those funds in emerging market bonds offering a significantly higher yield. An investor using this strategy simply has to hedge the currency movements and lock in the hefty yield differential.
Borrowing rates in markets such as the US, developed Europe and Japan are generally less than 2.5%. In Japan the borrowing rate is close to zero; in the US, the Federal Reserve recently raised rates to 1.25%. Contrast these with the yield that can be attained on a local R186 government bond at about 8.9%, and it’s clear the yield differential is substantial.
Also keep in mind that SA’s rand-denominated debt is still rated as investment grade (for now). Only one of the three major ratings agencies (Fitch) has downgraded this to subinvestment grade; the other two still put it one notch above that.
Two of three ratings agencies is sufficient to qualify our debt as investment grade on the whole. If, on the other hand, two ratings agencies downgrade SA’s rand-denominated debt to junk status, a huge exodus of foreign “hot money” is expected to flow out of the local bond market.
But we’re not there yet, and for now the hunt for yield continues. For the year to date, about R50bn flowed into the local bond market. This is what has driven the rand stronger. Foreigners now own almost half of all noninflation linked bonds — about R600bn worth.
So what could make this unravel? The flow of funds into the local market may have less to do with local factors and more to do with foreign ones. A rise in developed market yields is a big risk. If these rise further (they began to tick higher in the past month), it will make the carry trade less attractive. That could slow the demand for local bonds.
Throw in potential ratings downgrades later this year, and there could be a sudden rush for the exits that weighs heavily on the rand. The currency has already begun to weaken through its 18-month strength- ening trend as the yield differential has narrowed in the past month. This may be an early warning that the strong rand party is drawing to a close.
Those who have not taken advantage of the recent opportunity to export capital while the rand is strong should do so while the window is still open. The currency is unlikely to be as strong this time next year.