Optimism about lower interest rates

The Reserve Bank may cut interest rates sooner than expected as local inflation appears to be moving structurally lower, and the US Federal Reserve looks set to begin its own cutting cycle.

This is feedback from Old Mutual Wealth investment strategist Izak Odendaal, who said developments out of the US and China have a larger impact on the local economy than many think. 

“South Africa is geographically far away from both the US and China. However, what happens in these two giants probably has a greater impact on local investors than decisions made in the Union Buildings in Tshwane or the Parliament in Cape Town,” Odendaal said. 

This is because the US has an outsized impact on financial markets as the world’s largest and deepest capital market, while China is South Africa’s largest single export destination. 

Odendaal warned that considering how these two countries appear to be diverging on matters of crucial importance, South Africa will face difficult decisions in the years ahead. 

However, the more immediate story is very optimistic, with Chinese economic growth proving resilient, albeit materially lower than pre-Covid, and US inflation coming down, leading to potential interest rate cuts in the world’s largest economy. 

“The prospect of lower US interest rates is positive for local financial markets and supports the case for the South African Reserve Bank to start lowering its policy rate, if not this week, then at its next meeting.” 

Odendaal explained that US inflation has moved lower in recent months due to a stagnant housing market and elevated interest rates beginning to impact demand for goods and services. 

The housing market plays an important role in the US inflation story, with housing-related costs making up 40% of the core consumer inflation basket. 

This market has been on a downward trend since the middle of 2023, potentially opening the door for the Federal Reserve to cut interest rates. 

While this is clearly not 2% yet, inflation continues to move slowly in the right direction in the US. The risk that inflation can reaccelerate from these levels is not zero, but it is small. 

The greater risk at this point is probably that interest rates remain too high for too long, putting pressure on vulnerable sectors of the economy.

This means the Federal Reserve is likely to begin cutting interest rates sooner rather than later, opening the door for rate cuts in South Africa. 

Odendaal explained that the Reserve Bank sets interest rates with only one eye on domestic inflation and economic dynamics, with the other eye focused on the Fed. 

This is because capital tends to flow to where risk-adjusted returns are the highest, and investors can earn a risk-free 5.5% in short-dated US government bonds. 

Because of this, the Reserve Bank is hesitant to cut rates and reduce the relative attractiveness of South African assets compared to their US alternatives. This would weaken the rand and potentially lead to a rise in inflation. 

Thus, once the Federal Reserve moves decidedly towards cutting interest rates, the Reserve Bank will likely be a fast follower or perhaps even cut first if local inflation comes down sufficiently. 

Positive political developments in South Africa have also greatly increased the likelihood of the Reserve Bank cutting interest rates. 

The formation of a Government of National Unity (GNU) has boosted the value of local financial assets and strengthened the rand. 

A stronger rand significantly reduces headline inflation in South Africa, as the country imports many basic necessities, particularly fuel. 

With 85% of all goods in South Africa being transported via road at some points, the price of fuel has a substantial impact on inflation. 

Thus, a significantly stronger currency may push the Reserve Bank to begin cutting rates sooner than it would have otherwise.