Current Affairs: The Fed & the Rand

If Jerome Powell stands pat, things will look up. If, however, US rate hikes continue, expect a bumpy ride, writes Nigel Dunn

Despite some tentative signs of hope, and calls from certain leaders for South Africans to view the glass as half-full rather than half-empty, the most commonly held view is to sell the rand and externalise your domestic assets as the country will struggle to overcome the financial cost of a decade of poor policies and a litany of sins, many of which are finally being exposed.

Some of the populist policies being aired are exacerbating concerns.

SA has some structural issues that, until properly addressed, are going to be an economic challenge in the long term.

What we should look at is the daily chart of the dollar/rand ($/ZAR) in Figure 1, where there is a head and shoulders pattern with a potential count to 12.50.

If this plays out, it might be the best gift many receive going into the festive season. The fuel price will come down, helped by an even sharper fall in the dollar oil price recently.

There are two further charts that are instructive. A threeyear weekly close of the $/ZAR puts the trend line at 12.80 (Figure 2).

The second chart is the standardised regression residual (SRR) model of the $/ZAR over the same period. The SRR is currently close to +2 standard deviation above the mean. Historically, moves above or below two standard deviations have signalled turning points — these being January 2016 (R16.40) and February 2018 (R11.50). The question is whether September 2018’s reading of +2.62 will mark an intermediate low in the $/ZAR at R15.40, with a sizeable rally to follow.

The graphs and standardised regression model look interesting. However, one needs a catalyst to halt and reverse a trend that has been in place for a while. The most powerful and obvious is the dollar and, more succinctly, whether there can be a coherent argument made for dollar weakness in the coming months.

At face value the answer is “no”. Recent comments from Federal Reserve chair Jerome Powell painted a picture of an economy that is strong and expected to remain so.

He is committed to pushing ahead with rate increases. Consensus is for a further hike in December, and three next year. This will widen the interest rate differential between the US and the rest of the developed world.

The European economy continues to underperform the US. Politically Italy remains a concern and the budget it has put forward to Brussels remains a bone of contention (and is as yet unapproved). All three are supportive of further dollar strength.

I believe a strong dollar is the last thing the US and the world need right now, so perhaps some respite is coming, for several reasons.

The chorus is growing of those who believe the current rate-hiking path the Fed is on will trigger another financial crisis. Another two 25 basis point hikes will take the effective federal funds rate above the neutral federal funds rate for the first time since 2006/2007. Unless Powell stands pat, that will happen in the first quarter of 2019. Figure 4 illustrates that crises generally arise when the effective rate exceeds the nominal rate.

An increasing number of US companies appear to be at odds with Powell’s view of the economy. They are lowering revenue guidance as a result of dollar strength and higher rates

in calling for the Fed to stop hiking. US President Donald Trump may well be right — albeit for the wrong reasons. The US economy may be rolling over while the Fed is busy tightening. Trump would like to see a resumption of the bull market.

Trump’s fiscal policies are making onerous demands on borrowings. This comes at a time when he is alienating the US from many who previously funded US deficits, leaving domestic mutual funds, institutions and individuals to step into the breach. The note auctions in early November saw the lowest bid cover spread in close on a decade. Dollar bulls are effectively betting the Fed will not fund the government if required. That is a bold assumption, and the Fed may have little option but to turn on the printing press at some point. This should be dollar negative.

With the Democrats regaining control of the House in the recent midterm elections, Trump may be pressured to reconsider his stance on the trade wars — especially if markets post another month like October and economic growth slows.

There is another unknown: the composition of the Fed changes in 2019. It loses a hawk and gains a dove, while two positions remain unfilled. If those are filled by doves, at worse centrists, the balance of voting members will swing from an even position this year to a more dovish one in 2019.

There is also an esoteric point which may be worth considering. Carmen Reinhart wrote a piece in Project Syndicate highlighting the growing number of collateralised dollardenominated loans the Chinese have made to many emergingmarket (EM) countries over the past few years. The quantum and terms are not known. At a guess she believes EM sovereign debt is 15% understated. A strong dollar allied to weaker global growth — a consequence of the trade wars — is going to be a toxic cocktail for indebted EM counties, particularly those that borrowed heavily in dollars.

Former Fed boss Janet Yellen was always cognisant of the effects a strong dollar would have on EM counties — often mentioning it. Powell, on the other hand, has failed to mention the effects of the dollar on EMs. Is he oblivious to the dangers or has there been a deliberate change in policy?

If the latter, there are several direct consequences. First, it will hasten a global EM sovereign and corporate debt crisis. Second, it will result in the transfer of collateralised assets to China if borrowers fail to meet their repayment terms (you have the dollars, we get the assets). Finally, it will accelerate the de-dollarisation process.

Any one of those outcomes will not sit well with many both within and outside the US administration.

In conclusion, there are some compelling reasons for Powell to stand pat on rates, or at best signal a slightly less aggressive stance going forward.

Many enlightened commentators believe some of the recent growth has been attributable to heightened economic activity ahead of trade tariffs being implemented, meaning that growth in the coming quarters may moderate.

There are some equally sound reasons why Trump should tone down his stance towards China and other countries that previously purchased US debt.

US borrowing requirements are heavy, and a supply-side crisis (dearth of buyers) may be developing which could force rates at the medium and long end higher than many are comfortable with (Treasury included). With debt at record levels and rates moving higher, one must be concerned.

Readers will have to make up their own minds, as the investing implications could not be starker. If there is a continuation of the status quo, it will be difficult to make any compelling case to embrace risk assets at all. Expect markets to remain weak.

On the other hand, should Powell refrain from hiking in December or signal some cautious intent about the three slated increases for 2019, expect risk assets and markets to rally. Any moves by Trump to moderate his stance on China will amplify the gains.

The rand will strengthen and domestic counters — many having been in the doldrums post the February rally — will receive a much-needed fillip.

Picture: ANDREW HARRER/BLOOMBERG US Federal Reserve chairman Jerome Powell removes his glasses during a Federal Reserve board meeting in Washington in October.