May 2023 blowout in SA risk premia has reversed
The 100bp of growth and political risk premium priced into SA bonds post May 2023, on the back of loadshedding and Lady R, has reversed. While assets are by no means priced for a bull case scenario in SA, they are no longer priced for a bear case.
South Africa’s nominal yield curve bull-flattened in June and July, post the positive election surprise. The term and sovereign risk premia priced by SA assets compressed in the second quarter of 2024, such that the generic 10-yr bond yield fell 80 basis points (bp), to end the quarter at 11.23%, and a further 36bp during the first half of July, to 10.85%. The 10-yr yield is 25bp below our estimate of fair value. Foreigners bought R35bn worth of SA government bonds (SAGBs) in May and took profit in June with net selling totaling R8.6bn. Domestic investors did the opposite, with net selling of R16.6bn in May, and net purchasing of R34bn in June.
A breakdown of the components of yield compression shows that 23bp is due to a decline in US 10-yr real yields, 50bp from a compression in SA’s sovereign risk premium (as measured by the difference between SA dollar-denominated debt and US debt) to 260bp, and 20bp from the narrowing of the SA/US inflation differential.
Assessing the potential for further strength in the bond market, we note that the sovereign premium has averaged 340bp since SA was downgraded to non-investment grade in 2020, implying that it is unlikely to move sharply lower from these levels. A pick-up in the domestic growth outlook may, however, see a more gradual spread compression over 18 months, especially if it leads to expectations of a ratings outlook upgrade. We expect that further near-term bond strength will be due to a fall in US yields as the Fed starts cutting rates and the US growth outlook deteriorates. The risk to this view is a clean sweep Trump win in the November elections. We suspect markets are already attempting to price for this, although how to trade a Trump win isn’t unambiguous.
Rate outlook
Inflation data for SA and the US released in June suggest that upside risks have been tamed, despite July’s Monetary Policy Committee (MPC) statement that inflation risks are to the upside. Consensus has been building that both central banks would use their July meetings to open the floor to rate cuts in September. This has played out domestically and the SA Reserve Bank’s (SARB’s) MPC voted to keep rates unchanged, with two members voting for a cut, ostensibly providing guidance that the cycle will start in September.
The SARB lowered its CPI forecast to 4.9% for 2024 and expects it will dip below 4.5% over next few quarters due to slower increases in the prices of food and fuel, and a stronger rand. Medium term expectations are for both headline and core CPI to stabilise at 4.5%. The SARB theoretically makes interest rate decisions based on its estimate of CPI in 12 months’ time, which implies a real rate of 3.75%, 125bp above the SARB’s Quarterly Projection Model (QPM) real neutral rate assumption. Importantly, CPI excluding administrative prices is already at 4.5%.
We assume that because the data was supportive of a July cut, the SARB felt it necessary to list the reasons why it decided not to cut:
- US rates may stay higher for longer, putting pressure on the exchange rate;
- BER inflation expectations remain above 4.5%;
- Administrative prices are high and rising;
- SA has the second highest inflation rate amongst the G20;
- Global shipping prices are higher than at the time of the May meeting, due to disruptions in the Suez and Panama canals; and
- Although SA’s services inflation has been contained below global averages, it is beginning to rise.
Rand outlook supportive of cuts
Our rand view has changed post the elections. We expect that the USDZAR will trade in a 50-cent range around a midpoint of 18.20 to the dollar until the end of 2024. Thereafter we see the midpoint depreciating gradually to 18.90 by the end of 2025.
USDZAR scenario analysis
We think that the primary driver of the rand over the next twelve months will be the dollar. To incorporate the dollar more explicitly into our forecast we include it as an independent variable in our fair value model of the rand. We use the trade-weighted dollar as measured by the DXY Index on Bloomberg (an increase in the index reflects a stronger dollar) (Figure 1). Including the dollar, the USDZAR fair value is currently 18.50. Given that the currency is trading rich to fair value we see limited scope for significant further appreciation under current assumptions.
Our base case over the next 18 months is that the dollar remains at 103. Assuming the SA/US inflation differential remains at 2 percentage points (ppts) and that growth in real commodity prices is positive but muted, at 3.7%, the rand’s fair value is 18.90 by the end of 2025.
Scenario 1: If the dollar strengthens 5%, to 108, the USDZAR fair value weakens to 19.80 by 4Q25.
Scenario 2: For the rand to trade around a midpoint of 17.50 in 2025, and assuming the DXY at 103, commodity prices would need to strengthen 60% from current levels. We suggest this is unlikely considering current data releases coming out of China.
Figure 1: US dollar is structurally strong, and we expect it will remain at current levels
Source: Bloomberg, Matrix
The primary driver of the DXY Index is the EURUSD cross, which in turn is a function of the real rate differential between the US and the EU (Figure 2). The differential determines the direction of fund flows and remains broadly supportive of the dollar at current levels.
Figure 2: US/EU real rate differential is supportive of the dollar
Source: Bloomberg, Matrix
The reduction in SA’s sovereign risk premia priced by bonds and the currency, reduces upside risks to inflation and provides space for the SARB to cut rates. We expect rates to fall as much as 50bp in 2024 with the first cut likely in September. Importantly, the SARB has repeated its intention to lower the inflation target. This policy priority should also be supportive of the rand and should keep the cutting cycle relatively shallow.