South African rand goes from zero to hero

The rand has strengthened remarkably in recent weeks, hitting levels last seen in February 2024 as several factors combine to boost South Africa’s currency. 

This could potentially mark the end of an era in which the rand consistently weakened against the dollar by around 5% a year. 

The rand is a highly volatile currency and is one of the most heavily traded in the world. It is also largely seen as a proxy for sentiment towards emerging markets and commodity-dependent economies. 

Its strengths and weaknesses are also often a product of events outside of South Africa, particularly impacted by US interest rates and the performance of the Chinese economy. 

As the world’s dominant financial centre, what happens in the US gradually filters throughout the world. 

On the other hand, as the world’s second-largest economy and South Africa’s largest trade partner, what happens in the Chinese economy directly impacts local economic growth. 

In particular, China’s economic performance impacts South Africa’s foreign exchange earnings from commodity exports, influencing the value of the rand. 

However, Old Mutual Wealth’s Izak Odendaal said the formation of the Government of National Unity (GNU) has fundamentally strengthened South African assets, including the rand. 

Since the formation of the GNU on 17 June, it has surged around 6% in value – a far cry from the expected continuation of gradual weakening versus the dollar. 

While the rand has historically been very sensitive to external events, in the months following South Africa’s national elections, it has been steadily strengthening against the US dollar. 

This has only accelerated in recent weeks as the US Federal Reserve cuts its interest rates by 50 basis points, weakening the dollar. 

Odendaal said the case for front-loading interest rate cuts makes sense in light of the recent weakening of the labour market.  

Given progress on the inflation side of the Fed’s dual mandate, it is prudent to shift focus to its other goal of maintaining full employment.

However, the risk with a bigger cut is that it is interpreted as a sign of panic. The Fed has traditionally only cut by more than 25 basis points at times of crisis, such as when Covid hit in 2020, and in the Global Financial Crisis in 2007 and 2008.

The following day, the Reserve Bank cut local interest rates by 25 basis points, kicking off South Africa’s rate-cutting cycle in a much more cautious manner. 

The interest rate difference between the US and South Africa is a key, but not the only, driver of the rand-dollar exchange rate. 

This gap has declined over the past decade, which explains the weaker rand over this period, though the dollar also strengthened against other currencies, Odendaal explained. 

The interest rate difference should widen again somewhat as the Fed is expected to cut by more than the Reserve Bank. This should support the rand, all else equal.

Given the better economic outlook since the formation of the GNU, the cutting cycle is likely to be moderate. 

The repo rate looks likely to return to its pre-Covid level of around 7%, rather than falling back to the emergency 2020 level of 3.5%. 

The Reserve Bank assumes that a real (after inflation) repo rate of 2.7% is “neutral” neither stimulating nor constraining the economy. 

If inflation is at target, the assumed neutral nominal rate is, therefore, around 7%. 

This is still a fairly high interest rate, bearing in mind that few borrowers pay the repo rate; most loans are linked to the prime rate, which is 3.5% higher. Nonetheless, falling rates should provide some relief for consumers and businesses.

Mechanically speaking, lower interest rates should boost the valuations of other asset classes though cash returns will fall. 

The Reserve Bank’s more cautious approach and the Federal Reserve’s need to bolster the US labour market should see rates diverge further, despite both cutting. 

This will support the rand further as local assets become relatively more attractive than their American peers.  

The significant stimulus from the Chinese government in recent days should also translate into rand strength. 

If the stimulus has the desire affect of boosting consumer demand and investor confidence in China, then commodity prices should rise as the world’s second-largest economy comes out of its post-Covid slump. 

This will boost South Africa’s foreign exchange earnings as a major commodity exporter and strengthen the rand.