Rand Rally To Fire On Or Fizzle Out?

The Trend

The strong performance in higher yielding equity and bond assets has spilled over to currency performance; this has resulted in a boost for commodity and emerging market currencies. Following a decline of over 25% against the USD in 2015 for the local unit, the Rand reversed the negative trend observed last year to arise as one of the super stars of emerging market currencies. So far this year, the Rand has strengthened over 13% against the green back. The global clamor for yield has also been evident in this year’s spectacular performance by the Brazilian Real and the Russian Ruble, who have retuned over 19% and 10% respectively against the USD – this is after both currencies saw losses in excess of 20% in 2015.

The Rally

After significant portfolio outflows in 2015, the strength in many emerging market currencies has not been because emerging market fortunes have suddenly turned positive. An amalgamation of factors (and in particular the changing expectations of US monetary policy) has had implications for the pattern of global capital flows. This has led to the redirection of increased bond and equity portfolio flows away from developed markets and back into emerging markets. Growth in advanced economies has not been forthcoming and this is evident with various global central banks applying ultra-lose monetary policies to deal with current economic headwinds. There has also been an increase in political risk with U.S. elections fast approaching and the world still awaiting clarity post the Brexit referendum vote. According to the institute of International Finance (IIF), the body estimated that non-resident portfolio flows to emerging markets reached $24.8 billion in July – this follows $13.3 billion in June. In the weeks following the Brexit vote, there was a pronounced pickup in investor interest in emerging market and other risk assets, as investors were faced with a world of near-record low global yields. Understandably, the Rand exchange rate has been sensitive to these developments. Just last week, the local currency reached its best level against the USD this year, dipping below the R13.40 level. In the same week, the MSCI Emerging Markets Index also rallied sharply to hit a 13-month high after gaining 3.9%. Furthermore, the local unit has also gained 10.9% against the Euro in 2016 and a whopping 23.2% against the Pound Sterling. The Rand rally also aided South Africa in clawing its way back to first position as Africa’s largest economy in dollar terms. This is after being temporarily relegated to third position earlier this year.

The Fizzle

Although the Rand has been a stellar performer so far in 2016, we have certainly witnessed volatility which has been a combination of both global and local factors. Recently, S.A saw positive economic data in the form of manufacturing and mining production numbers, which almost ensures that Q2-16 economic growth will be positive and thus a technical recession may be avoided for now – should this all be favourable for the Rand. However, the Rand remains vulnerable to possible “risk-off” global scenarios. This places into question the sustainability of the current reversal of EM capital, as during periods of stress these flows can dry up and cause the Rand to depreciate. One such risk that could derail the Rand rally is monetary policies by central banks. The latest jobs numbers out of the U.S. surprised to the upside, but failed to sway market participants away from the notion that the U.S Fed will act more slowly in raising interest rates. Even though it is widely expected that the Bank of England (BoE), the European Central Bank (ECB) and the Bank of Japan (BOJ) will remain accommodative in their monetary policy stance, the Fed, will at some stage resume the normalisation of interest rates. This will bring monetary policy divergence back into sharp focus as the US yield curve starts to lift and the USD regains its strength; at this time this may lead to the local currency relinquishing its gains as it comes under renewed pressure in the face of changing global dynamics. A caveat to this is that history has shown as far back as the 1970’s a rise in the federal funds rate has not typically been associated with a strong USD as most seem to believe.

Apart from Fed moves, China could return as a major influence in global financial markets in the coming year as the country continues to rebalance its economy. We should not forget the commodity cycle either, which has significant implications for commodity market currencies such as the Rand.