Good news about interest rate cuts in South Africa

The Reserve Bank has substantial room to cut interest rates at its next meeting, with inflation continuing to surprise on the downside and the rand showing surprising strength. 

This is feedback from Old Mutual Wealth investment strategist Izak Odendaal, who outlined the rand’s resurgence in recent weeks. 

The rand’s bounce back is crucial for interest rates in South Africa. Its strength allays fears of a disorderly decline in its value. 

A sharp decline in the currency’s value amid elevated global uncertainty would significantly increase the cost of importing goods into South Africa, raising inflation.

The Reserve Bank has been concerned about such a disorderly decline, opting to keep interest rates on hold despite inflation falling to the lower end of its 3% to 6% target range. 

South Africa’s headline inflation rate fell to 2.7% in March from 3.2% in February, the lowest level in four years and below economists’ expectations.

The Reserve Bank has been deeply concerned about the impact of volatility in financial markets on the rand and other South African assets. 

This has made it cautious to cut interest rates aggressively as it would make South African assets more vulnerable to increased global risk aversion. 

This is because an interest rate cut would reduce the risk-adjusted return of South African assets, potentially resulting in money flowing elsewhere.  

Given heightened global trade policy and geopolitical uncertainty, this can result in pronounced currency weakness and higher imported inflation.

The Reserve Bank can also reasonably conclude that South Africa’s low growth environment is not primarily due to the elevated level of interest rates. 

This means that cutting rates more aggressively would do very little to stimulate economic growth in the country without significant reform.

It may also prefer to see inflation anchored around the bottom end of its target range at 3% for a longer period of time. 

While a 4.5% inflation outcome is an improvement from prior years, it is not in line with global inflation targets and contributes to the rand’s steady weakening versus major currencies.

Interest rate cuts on the cards

Odendaal explained that all is not well with global financial markets, with commodity prices showing that investors expect a slowdown in economic growth and perhaps a sharp increase in inflation from tariffs. 

Though the gold price is off its record highs, it is still 22% higher since the start of the year, while oil is 16% lower. 

The former points to elevated investor unease, while the latter suggests weaker economic growth ahead. 

However, it will also reduce inflationary pressures worldwide and support the case for central bank rate cuts, Odendaal said. 

This includes South Africa, where inflation surprised to the downside yet again in March, giving the Reserve Bank further room to cut rates. 

Crucially, the rand has also strengthened recently against the dollar, easing potential fears about a disorderly decline in its value and imported inflation. 

Odendaal explained that this is more because of dollar weakness than inherent rand strength, with the trade-weighted dollar index falling to its lowest level in three years. 

This indicates that investors have fled from the US dollar and American assets at a time of uncertainty, which is alarming considering they are traditionally seen as safe-haven assets. 

Instead of running towards the dollar, investors fled, with the trade-weighted dollar index falling to the lowest level in three years. 

It remains elevated relative to its longer-term history and potentially has further room to fall if the growth outlook sours and the US Federal Reserve starts cutting rates. 

If the US Fed begins cutting rates, the risk-adjusted return of assets such as US Treasuries will decline, making them relatively less attractive to investors.

Moreover, given erratic US policymaking, international investors could continue to rebalance their portfolios away from American assets after being massively overweight over the last decade. 

This would be a cyclical move out of dollar assets, potentially threatening the dollar’s role in global finance and commerce. However, Odendaal said it is too soon to know for sure. 

For the time being, there is simply no credible alternative. But Odendaal said the fact that the question is being discussed is telling.