The rand’s strength seems to be more a func­tion of for­eign fac­tors than lo­cal ones

Financial Mail - Investors Monthly - - Contents - GARTH MACKEN­ZIE www.trader­

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.

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