Hidden force behind rand strength

Central banks in 37 emerging markets have begun cutting interest rates before the Federal Reserve and South Africa’s Reserve Bank, making local assets more attractive and strengthening the rand. 

Stanlib chief economist Kevin Lings said the Reserve Bank has been extremely conservative in its approach to tackling inflation and interest rates. 

At Standard Bank Investment Solutions’ Democracy and Markets event, Lings said this is likely due to 2024 being an election year and the bank’s fixation on its inflation target. 

The Reserve Bank has hesitated to cut interest rates while the country’s financial markets have been uncertain due to the election and its outcome. 

It would have been unwilling to add further uncertainty by cutting interest rates unexpectedly and sooner than initially expected.

Furthermore, inflation has not returned to the midpoint of its target range of 3% to 6%. It is hovering around 5%. 

Thus, while the Reserve Bank was quick to hike interest rates to tackle inflation, it has been slow to cut rates out of fear that it might reignite inflation. 

Lings said this has a hidden benefit for South Africa. Not only has the Reserve Bank proven its world-class ability, but it has also boosted local fixed-income assets. 

As interest rates are hiked, the interest paid out to investors on fixed-income instruments, such as bonds, rises – making them more attractive. 

This effect is turbocharged when other central banks cut rates, and South Africa’s remain high. This increases the yield differential on fixed-income assets, making them more attractive to foreign investors. 

With 37 countries cutting rates before the Reserve Bank, money will flow into South African fixed-income instruments and support the rand. 

Emerging markets, including South Africa, are in a better position than ever to begin cutting interest rates before the US Federal Reserve. 

Typically, when the Federal Reserve begins its interest rate-cutting cycle, emerging markets experience tremendous financial pressure.

In some cases, this leads to debt defaults as these economies are highly vulnerable to movements from the US central bank.

However, this is notably different in 2024 as these economies have built resilience to external shocks through positive fiscal reform. 

Many emerging economies have adopted floating exchange rates, built up foreign exchange reserves and reduced foreign borrowing.

This makes them more resilient to the Fed’s movements and allows them to cut rates if their local inflation drops sufficiently – without waiting for the Fed to cut first. 

Some emerging markets hiked rates aggressively and early, even before the Fed got going in 2022, giving them a headstart in the fight against inflation.  

These countries, including Brazil, Chile and Hungary, can now cut rates as domestic inflation has declined, even though the Fed has yet to move lower. 

As they continue to cut, South Africa’s short-term interest rates no longer seem relatively low in the peer group, and that should take some pressure off the rand.

South Africa may also find itself in the same position as its peers, in being able to cut rates without waiting for the Federal Reserve to. 

Lings said the Reserve Bank could cut rates before the US if local inflation drops below the midpoint of its target range. 

Standard Bank chief economist Goolam Ballim cautioned against this possibility, saying that cutting before the Federal Reserve may weaken the rand. 

This has the potential to reignite inflation by making it more expensive for South Africa to import goods, particularly fuel. 

Ballim and Lings said the Reserve Bank’s job is not done. It has to walk a fine line to avoid reigniting local inflation. 

Furthermore, while it has to keep on eye on local inflation, it also has to watch global developments closely, particularly in the US and guard against external shocks.