Rand holds firm as a wave of worry washes over the world

The rand is holding up remarkably well as risk-off sentiment washes over global markets on geopolitical tensions and the prospect of rising US interest rates. But how serious are threats to global investor appetite and can the local currency withstand them? In previous risk-off bouts, the rand has whipsawed wildly because of its unenviable position as one of the most liquid emerging-market financial systems and forex markets, which investors treat as a proxy for feelings about emerging markets at any time.

This time the rand has held relatively firm as Russian troops have massed at the Ukrainian border and global markets have sold off in anticipation of expected interest rate hikes by the Federal Reserve this year.

SA equities sold off 3.6% on Friday last week and the S&P 500 fell sharply before regaining ground towards the end of the day. Oil prices fell 3% on concerns about the impact on demand of the events in play. In contrast, commodity prices have held firm, advancing 6.5% this year so far. Commodity prices are expected to be the primary beneficiaries if the US-Russian standoff intensifies or, at worst, Russia invades Ukraine and is hit by strict sanctions from the West.

ING notes that the combination of the risk introduced by Ukraine and disorderly moves in the equity markets have already started to take their toll on high beta currencies. As the wall of worry grows, the rand’s fundamental positioning in the global foreign exchange markets will, to some extent, determine how it responds to unfolding events.

In a recent assessment of foreign exchange rate misalignments, the Institute of International Finance found the rand overvalued to the tune of 12%. Other emerging markets with overvalued currencies are Argentina, Colombia, Egypt, India and Mexico.

This contrasts with the views of Old Mutual Investment Managers investment strategist Izak Odendaal and Sanlam Investment economist Arthur Kamp, who consider the currency slightly undervalued.

Odendaal says it is notable how well behaved the currency has been despite the jump in global risk aversion, particularly because this jump is caused by expectations for tighter US monetary policy. Usually, he says, you’d expect the rand to be high up in the list of victims. He attributes the difference this time to (a) commodity prices remaining relatively fair and (b) the weakening in the rand towards the end of last year.

“I don’t think the rand is overvalued. Overvalued is when you’ve received a flood of capital, imports are exploding, foreign borrowing rises and your exporters can’t cope. We’re clearly not there,” he concludes.

Kamp bases his valuation on purchasing power parity but notes that determining equilibrium value for the currency is difficult and views can differ markedly.

The IIF’s measure is based on a complex combination of adjusting the current account for the lagged effects from past exchange rate moves and making a cyclical adjustment, based on its assessment of output gaps at home and abroad, it explains.

It has taken the measure of emerging markets forex rates in this way since early 2018, when the Turkish lira was significantly overvalued. How the tide turns; now the Turkish currency is one of the most significantly undervalued currencies.

Any economist will tell you that trying to pin down over-or undervaluation is a mug’s game because the world’s largest and most liquid financial market is even more subject to the vagaries of investor sentiment than the equities market. However, trying to narrow down a fundamental valuation does give you some measure of confidence when needing to make decisions like investing overseas or buying international goods down the line.

Things could change quickly in the next quarter because, as Odendaal cautions, “When the US central bank moves interest rates, it is like tectonic plates that shift underneath all global financial markets – bonds, equities, currencies, the whole lot. If all goes according to plan, the shifts will be gradual and barely noticeable. If not, we should expect tremors. So far this year it hasn’t been pretty.”

Looking forward, Kamp argues that undervaluation of the rand does not guarantee its appreciation against the US currency. “Much will depend on the path of US interest rates and the relative strength of the US dollar. If the US Federal Reserve acts more aggressively than expected it could get bumpy. In a risk-off environment the rand would likely battle to appreciate.”

If the Fed hikes as expected, the SA Reserve Bank is likely to raise its repo rate to maintain its inflation targeting. Anchoring inflation and inflation expectations at a reasonably low level should help reduce rand volatility over the longer term, says Kamp.DM168