Fed’s caution may spare SA worst of rates fallout

NON-FARM employment in the US grew by 271 000 in October — the fastest rate so far this year, and well above market expectations. There was also a cumulative upward revision of the jobs numbers for the previous two months. The result is that net job gains have averaged 187 000 over the past three months and the US unemployment rate remains at a post-crisis low of 5%.

There is strong evidence even beyond the headline numbers to suggest that the US labour market is strengthening. For example, the number of involuntary part-time workers has declined by 1.2 million over the past year to 5.8 million. And wage growth in October quickened to 2.5% year on year; the fastest rate in six years.

The strong labour market report suggests that US economic growth momentum remains solid, despite overall global growth being soft. This has increased speculation that the US Fed will begin raising interest rates at its December meeting.

Rising US interest rates matter for South Africa, and for countries like ours, because they affect our financial markets and the real economy.

The prices of risky assets such as equities are driven by the rate of profit growth and the interest rate with which those profits are discounted. Therefore, risk-asset prices can increase significantly even in an environment of muted but stable economic and profit growth — as long as rates are very low.

Thus, despite only a muted recovery in South Africa’s economic growth from the 2008-2009 global financial crisis, the performance of the South African equity market has been stellar. The JSE’s All Share index bottomed at a level just shy of 18 400 in October 2008. This year, it was trading at near-record highs of 54 000 in the first week of November.

This strong performance has, in part, been driven by the extremely easy money conditions engineered by the Fed since 2008. The Fed has kept the cost of money low through a combination of its zero interest rate policy and the various Large Scale Asset Purchase Programmes, better known as quantitative easing (QE). By keeping US interest rates exceptionally low, the Fed has supported global equity prices, South Africa’s included.

By making emerging-market assets attractive, exceptionally low US interest rates and QE have also underpinned emerging-market currencies such as the rand, because this encouraged portfolio inflows.

QE began tapering off in 2013 and ended in 2014. For the past year, financial markets have been discounting the start of the Fed’s liftoff, but the recent non-farm payrolls report has increased the expectations that the Fed will begin raising rates in December. South African equities, along with those of other emerging markets, have lost ground as a result.

In addition to causing volatility in equity prices, this period of speculation about higher US interest rates has coincided with the dollar appreciating by, for example, 20% against the euro since January 2014.

The flip side has been a significant depreciation of other currencies, particularly those of commodity exporters. For example, the rand is 30% weaker against the dollar than in January 2014; the Brazilian real 59% and the Australian dollar 25%.

It is feared there could be further and sustained exchange-rate weakness, particularly among vulnerable twin deficit emergingmarket economies such as South Africa. The expectation is that this would place significant upward pressure on inflation, inviting the Reserve Bank to raise rates by much more than is expected.

The Reserve Bank is likely to raise rates gradually over the next year because inflation is expected to rise largely thanks to the weak rand. The rand could weaken further when the Fed starts raising rates. But the extent and duration of that depreciation would depend on the Fed hiking cycle, which is likely to be a key topic in 2016.

However, after having done so much to support the US recovery through extraordinary monetary policy intervention, it’s difficult to see the Fed putting the US recovery at risk by raising rates aggressively. Also, an aggressive hiking cycle could go hand in hand with an even stronger dollar, particularly given the fact that the European Central Bank and the Bank of Japan are going in the opposite direction. Further sustained dollar strength would hurt the US economy and place downward pressure on US inflation. The Fed is likely to respond to this by emphasising the gradual nature of its hiking cycle.

Nxedlana is FNB chief economist