South African rand targets new milestones

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By Cees Bruggemans, Chief Economist of FNB.

Having successfully breached 11:₤ and 10:€ on the downside, and reaching 7.30:$ once again, it is a serious question whether the Rand can reach yet newer milestones this year (like 9, 8 and 6 before the comma).

Rand strength against Sterling and Euro mainly reflects cyclical (and structural) weaknesses in these latter currencies, while cyclical forces continue to favour the Rand (though few people seemingly paying much attention to its long-term structural weaknesses).

Unless and until there is a change in this force lineup the Rand could keep firming.

Late last week one global bank commented that South Africa has one of the highest bond returns (presumably risk-adjusted) offered by emerging markets.

That may mean global appetite for our bonds is far from finished. Also, with our corporate earnings cycle turning up on the back of growth, good productivity gains and reducing debt write-offs, there should be appetite for our corporate assets.

More rather than less foreign capital could be streaming towards our shores unless risk aversion can be reactivated, inhibiting such flows.

There remains hope that Europe can sort out its squabbles soon, arresting the Euro decline. Yet not all share such hope. As to Britain, one wonders what miracle could possibly halt its slide soon. Instead, a hung Parliament beckons during which little decisive may happen.

Germany seems temperamentally unwilling and legally unable on statutory grounds to bail out spent-drift neighbours. The focus remains on getting such neighbours to swallow bitter medicine. In contrast, other Europeans favour greater solidarity. Also, some advice such countries to go cap in hand to the IMF, though not all agree with this suggestion.

No European lifelines seem to be forthcoming soon, not even (as frequently imagined in recent months) a vague safety net aiming to get periphery borrowing costs down (but not actually intended to be used). And thus the periphery position seems as nakedly forlorn as ever.

It forms a very strong message to all straying brethren on the European periphery. Sink or swim on your own volition, we will watch and decide accordingly.

Whether this will lead to country default(s), ejection from the Eurozone (favoured by some, rejected out of hand by others) and even a (partial) breakup of the Eurozone remains to be seen.

Ultimately such core discipline argues for a stronger European romp (reminding of the 1970s). Also, German Chancellor Merkel seems inclined to cut German taxes next to placate her disillusioned voters (in the process also assisting the European outlook, if such tax cuts are spend rather than saved, which doesn’t always happen in Germany).

Despite the ‘constructive ambiguity’ of the moment (telling taxpayers there won’t be a bailout and telling markets there will be a safety net), Greek cash flow realities in April/May could ultimately force the issue in yet more creative ways. Markets could even come to the conclusion Greek efforts are courageous and credible, as suggested by ECB President Trichet, reducing risk premiums. It argues for eventual Euro recovery.

For now uncertainty weighs on the Euro. Thus there remain those willing to bet against the Euro. Some see potential for another 8% decline to 1.25 $:€. Others, possibly more adventurous or decidedly more skeptic about European abilities to agree anything imaginative, see potential for even triple that.

At 1.35 $:€ there is 25% Euro decline to go to Dollar parity (if that were to be the eventual end destination). Such an outcome would be awful to contemplate for Europe’s many competitors.

The Rand for instance. How would 7.00-7.50:€ appeal to you? That would be truly disastrous for many of our remaining agricultural and industrial exporters.

This is not a forecast. Just setting some milestones and wondering aloud whether these could be achieved.

Regarding both the Euro and the Dollar it has to be appreciated that core inflation in both Europe and the US is now below 1% and still sliding towards the dreaded zero (and deflation). It is something that the respective central banks are deeply determined to prevent.

So whatever else happens, neither ECB nor Fed will be raising interest rates this year. Indeed, depending on events they may not raise until deep into next year (though a precipitous Euro decline towards parity might provide grounds for the ECB to act earlier).

With short-term interest rates likely to be on hold for still at least a year (and possibly longer in the US), the outlook for risky global assets remains attractive unless events were to come along reactivating risk aversion and the Dollar safe haven inflows.

China is apparently taking pre-emptive action to prevent too much disruption, aiming at an orderly evolution of financial policy changes (monetary tightening, currency appreciation, government demand for property). As such China needs not to turn into a sudden risk surprise.

The European condition is similarly evolving. What is at issue there is the specific nature of its cleanup rather than whether there will be one.

Periodic fears about central bank exiting strategies and bouts of poor data releases will presumably from time to time make markets pull back (correct).

But the main force will presumably be gradually declining anxiety (uncertainty) worldwide in the presence of record low interest rates in the US, Europe and Japan, driving capital flows towards higher yielding periphery assets.

Given South Africa’s positioning in the world (emerging economy, commodity producer, great corporate assets, great public bond returns and deep macro policy orthodoxy) global capital will presumably keep beating a path to our door, besides supporting our export prices.

That makes us a major reflating trade in 2010, just as in 2009. Last year we gained 50% on our equity prices and 30% on the Rand. Even half such gains this year would be enormous for us.

It means targeting 35 000 or more on the JSE All Share (unthinkable, right?) and the Rand reaching towards 9, 8 and 6 before the comma against Sterling, Euro and Dollar respectively (even more unthinkable, right?).

This currency drift will end sometime, but it may take a while during which our furniture gets rearranged.

It could also mean a severely repressed inflation rate through 2011 despite very high public sector tariff charging. Shades of 2003-2004 when CPI inflation fell below 3% for a while.

These are not forecasts, only possible new milestones. Just in case nobody had realistically thought about them.

Source: Cees Bruggemans, FNB, March 23, 2010.

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