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Morning ideas |
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Morning ideas
The rand: Why is it as strong as it is?
The recent strength of the rand will have puzzled many. The trade weighted rand gained about 7% in July. Clearly rand strength is not explained by higher commodity prices. Gold, platinum and oil are all lower than they were and the rand has made significant gains on the Aussie dollar - the commodity currency par excellence. Packing for Perth, the rand is now 9.43% cheaper than it was a month ago. Nor can the strength of the rand be attributed to emerging equity market trends. The EM benchmark is down nearly 4% on a month ago suggesting that money has flowed out of rather than into emerging equity markets. And so the usual suspects for rand strength have perfect alibis.
The strength of the rand has however coincided with very significant developments in the fixed interest space. Long bond yields declined dramatically last month. The yield on the R157 was 10.7% on 1 July - it is now offering 9.32%. At the short end of the yield curve belief in a further increase in the Reserve Bank’s Repo was held with great conviction. Today it is as confidently predicted that the SARB will not be raising its key lending rates next week.
Thus we have noticed rand strength with lower rather than higher interest rates; a relationship that is also not entirely consistent with our prior views on this relationship. However it might be argued that it is offshore flows into rand denominated fixed interest securities that have driven interest rates lower and the rand higher. But if so it would need to be explained why bond investors acted in the way they did. In other words, why they thought the interest carry in favour of the rand was suddenly attractive when it had failed to attract them before? Clearly an interest carry is only attractive when what is gained on the interest rate leg is not lost when the interest rates are converted back into the originating foreign currency. Interest rate differences are only attractive when accompanied by favourable exchange rate expectations. It may be concluded that because SA interest rates have receded it is not only that the spot rand has strengthened but also that expectations of the value of the rand going forward have been revised upwards.
It’s a growth story now
A month ago the prevailing fear was that the inflation fighting Reserve Bank would continue to raise rates as inflation continued to increase, so throttling the life out of the SA economy. Since about a year ago fears of ever higher inflation and ever slower growth, which economists describe as stagflation, drove the rand weaker ever lower as foreign equity investors turned away from SA economy plays including banks and retailers listed on the JSE. A combination of a weaker rand with rising commodity prices was by contrast the equivalent of heaven for investors in JSE resource stocks.
The tide has clearly turned dramatically. Weaker commodity prices and a stronger rand are the equivalent of hell for resource stocks. Lower interest rates represent much better news for the SA economy and the SA economy dependent enterprises listed on the JSE. This better news has been reflected in improved valuations. In July, our Index of SA economy or rand plays gained nearly 10% while the stocks that benefit from rand weakness – those we call rand leverages – lost over 23% of their value of 1 July.
The conclusion we come to about the rand is that it has gained the strength it has because the growth outlook of the economy has improved with lower interest rates. This would seem to confirm that the most important consideration for foreign investors, whose capital is so important for the value of the rand, is the growth outlook for the SA economy. With the danger of higher interest rates falling away and the prospects of lower interest rates to come, as inflation helped by a stronger rand and lower oil prices recedes, the case for investing in rand based securities has improved. This is why the rand – we think – has strengthened. It is the feedback loop from faster (slower) growth to a more (less) favourable exchange rate for the rand that remains intact. Brian Kantor
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Posted on Wednesday, August 06, 2008 (Archive on Wednesday, August 13, 2008)
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