Cees Bruggemans: Consulting Economist Bruggemans & Associates
Cees Bruggemans: Consulting Economist Bruggemans & Associates



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Indian Summer for SA Rand?

2014-05-13

After a 30 month streak of non-stop weakening between mid-2011 and early 2014, taking the Rand from near 7:$ to 11.40:$ (a 60% move), the early months of 2014 witnessed a pullback or correction, so far reaching 10.35:$.

Has the downward Rand channelling been broken or does it remain intact? Or is there a decisive if temporary break occurring, an Indian Summer, in between long bouts of Rand breakdancing?

The key observation in all this Rand behaviour is that it is not primarily reflective of domestic conditions. Instead, the Rand travels in Emerging Market (EM) convoy, to the beat of global drummers - mainly disruptive events and the intervention of major central banks, the Fed especially.

Mid-2011 coincided with the peaking of the global commodity supercycle, disruptive risk events focusing on US debt ceiling and government shutdown, and Eurozone crisis conditions.

Slowing global growth since then, especially focused on China and commodities, had a negative connotation for EM currencies. What really changed the market risk/reward configuration adversely was caution about eventual Fed policy normalisation, speculation about QE bond buying tapering starting, its eventual occurrence and the focus increasingly shifting to the likely schedule of Fed rate normalisation.

All these push factors, and the internal growth weakening in many EMs while this transition was playing out, gave rise to bouts of EM capital outflows (defensive withdrawals), further kicking EM currencies down the stairs, and in a number of instances (India, Brazil, Indonesia) giving rise to substantial interest rate tightening, mainly in support of the currency and anti-inflationary in its focus (SARB also so following through last January with a 0.5% rate hike).

But since then, for the past three months since early February, there has been a break in the clouds, coinciding with Janet Yellen taking the Chair at the Fed. EM currencies have strengthened, the most sold-off doing so impressively.

One of the main reasons appears to have been a maturing view in markets regarding Fed tapering, getting a better grip on its implications. The consequences after all didn't turn out to be dire (necessitating a continuous fast run up in yields and Dollar).

Instead, the whole transitioning remained incredibly benign, with US growth proceeding modestly, resource slack taken up only very gradually, no evidence of acceleration anywhere and the Fed giving no inkling of doing a Volcker shortly (suddenly turning aggressive).

With taping turning out easily digestible (even being a relative non-event in a greater context), with markets not becoming dislocated, the focus increasingly shifted to the future schedule of Fed rate hiking - and here more of the same seemed to beckon.

In a word, risk calmed down, reflected in renewed dramatic easing in volatility across markets. Also, it helped that EM performances stabilized, with growth prospects in some improving, also considering political election cycles and the possibility of reformers getting in.

Events of recent weeks have reinforced these sentiments, despite geopolitical turmoil in the Chinese seas and especially the Ukraine. Though these regional stresses did weigh on markets, the bigger influence so far has been the steady performance of the US and European economies, and the Yellen message, with of late the ECB's Draghi increasingly also making his presence felt.

Despite some evident communication struggles, Fed chair Yellen has succeeded in selling the main message, namely that US growth is steady and warrants QE tapering to proceed, but that the growth modesty and slow US resource uptake, with large labour resource pools remaining, also warrant only a very gradual and prolonged Fed policy normalisation.

Consequently, Fed rate hiking will probably only start fairly late (in 2015) and proceed very slowly, and only to the extent that the US economy can handle it. With markets buying in, risk acceptance has improved, to the point of danger signs for 2014 receding, and risky assets being rerated stronger.
As if this major Fed role wasn't enough, the European condition appears to be gearing up for a major supportive role as well. EU growth remains excruciatingly slow and inflation undershooting 2%, with political restraints disallowing the kind of US fiscal proactivity seen in its post-crisis years.

With the EU parliamentary elections out of the way shortly, the ECB has gradually positioned itself for more policy belt-loosening, bearing in mind the huge geopolitical uncertainty hanging over proceedings emanating from Russia.

Last week, the ECB kept its rates once again unchanged but Draghi gave a dramatic signal, saying it WILL ease policy next month (June), implying the start of very mild negative interest rates.

Considerable uncertainty remains about possible stepped up ECB asset buying (suffering institutional and political restraints, but possibly also kept in reserve, depending on a more dramatic growth weakening and inflation undershooting, event-related, specifically Russian based).

Markets have for some time been speculating about more ECB action, but only did so aggressively following the latest Draghi comments, setting in motion lower bond yields across the region, and Euro easing.

Both these Fed and ECB plays may have further to run this northern summer of 2014 as the dovish Yellen message prevails and the lumbering ECB swings into action, further easing policy.

The message for global markets is bond yield declines, delay in Dollar strength but nonetheless a bias to Euro weakness, and this boosting global equities, but especially high-yield EM bonds, equities and currencies, continuing the bull-runs in progress.

But will it only be a 2014 Indian Summer that will end with another descent into a new bout of breakdancing in 2015?

Here, there are two observations, one focused on the Fed and the other on the ECB, with Asia (China, Japan) kept in reserve (but still actionable).

The Fed will at some point start its rate hiking, finally normalising its rate structure. This process will presumably start sometime in 2015. The key question to be answered, and endlessly worried about, is whether this will be a disruptive shock progression, difficult to digest, changing risk configurations for the worse once again? Or whether, like tapering bond buying in recent months, it will prove more benign and digestible in a normalising economy than so far allowed, with less of a market repositioning than now imagined?

This Fed rate normalisation certainly will be a learning curve. And even if it proves largely digestible without shock, it still implies higher US rates, better resource take-up and therefore presumably a stronger Dollar.

Risky EM asset markets may therefore still expect strain out of this adjustment and transition, even if it need not prove derailing (sudden capital reversals).

Despite returning bouts of volatility, risk markets may continue to do relatively well, considering the circumstances. But what will EM currencies do?

The Indian Summer ending and the eventual resumption of breakdancing analogy suggests that the present lull can extend deeper into 2014, accompanied by further EM currency recovery, but that 2015-2018 can see renewed EM currency weakness as the mighty Dollar reasserts itself, and it all depending on the pace of US adjustment, benign or less so.

This suggests a Rand outlook for 2014 of 9-11:$, still largely an extension of the 2011-2013 weakening channel, but potentially a peaking out or stabilisation thereof, followed by a new weakening channel starting sometime in 2015 on the back of Fed policy actions driving the Dollar stronger and forcing renewed risk reratings globally, with this lasting through 2016-2018 before peaking anew.

My sense about such American transitioning is that it will remain digestible and mostly benign.
To which I want to add an increasingly active European component (and still keeping Asia in reserve, as for now I am not sure what to assume there).

The ECB shift to resuming active policy stimulus may be a neutralizing force for what the Fed will be doing, making the transition even easier for EMs.

Even so, ECB policy action in response to internal European developments are so far still assumed to remain very modest. If, however, Russian moves were to become more assertive during the coming year and into 2015, it may require greater ECB assertiveness in return, neutralizing any growth and inflation undershoots.

Such geopolitical disturbances could fan uncertainty and risk-adverseness. But policy action could support risk, as seen before with the Fed (and incidentally with the ECB, considering how the peripheral EU markets have normalized).

My main sense would be to expect more ECB support than currently discounted for all these reasons. It could turn out more supportive for EMs, too, despite bouts of shock volatility.

And it could reinforce the Fed to go more slowly yet, too, in its transition, if US risks of undershooting were to return.

Such considerations may not make 2014 an Indian Summer in between bouts of extensive breakdancing. Instead, the 2011-2013 Rand depreciation has for now ended in Rand undervaluation. An extensive period of sideways movement in a broad channel, with periods of recovery alternated with shock weakening, could be with us for much longer, also post-2014.

That gives a 8-12:$ trading band through 2016, with a high probability of remaining within the inner core (9-11:$) for long stretches.

That would be good for the SA inflation trajectory, limiting its upside this year to 6.5%, with relapse back into the 3%-6% target range from 2015.

In turn, it would cap upside SA interest rate potential, unlike the far more globally aggressive off-the-wall scenarios discussed in my January Comments.

We seem to be at a crossroads. My sense is for Fed dovishness and gradualness and EBC reassertion of support, with Russia a major policy tail risk.

The bottom line, though, would suggests contained EM risk in response to global monetary normalisation, with the transition muted and prolonged, and very serially, with the Fed embarked tentatively, but Japan staying proactive and the ECB becoming so, possibly in unexpected stages.
This could spell more external stability for us than assumed by many, and for much longer than now discounted. Good for asset markets, including the Rand, assisting our inflation to be better contained, and interest rate policy possibly less assertive than so far assumed.

No SARB rate hike this month. July's outcome Ukraine and Rand dependent?
 
Cees Bruggemans
Consulting Economist
Bruggemans & Associates
Website  www.bruggemans.co.za
Email  economics@bruggemans.co.za
Twitter  @ceesbruggemans
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Indian Summer for SA Rand?

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