Rand and prime prospects

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By Cees Bruggemans, Chief Economist of FNB.

Many things are muddling the Rand outlook this year and next. Will the Rand still firm, or start a new weakening cycle, and can it differ per major currency?

The Rand should still firm nearer or even below 7:$, except that a ‘strapless bra’ condition seems to be holding up the Dollar.

The near zero US short-term interest rates offer no return on cash, encouraging capital outflows from the US, as was the case for much of last year, potentially weakening the Dollar and firming the Rand.

But countering these outflow pressures are many other forces making for a firming Dollar, and possibly offering a cap (if not some downside) to the Rand.

Firstly, large US bond issuance and lingering fear among bond vigilantes, fed by inflation caution and sovereign debt default potential elsewhere, has pushed US 10-year yields higher to 3.7%, well above German bund 10-year yields of 3.1%, comfortably compensating for any US risk, supporting US bonds and capital inflows.

Secondly, US economic data suggest reasonable growth prospects, bolstered by strong US corporate earnings recovery, reinforcing appetite for US equities (inside and outside the US).

Thirdly, increased sovereign risk (especially European) is making the US look more attractive risk-wise.

Despite the Fed probably staying on hold near zero, even far into 2011, these features are Dollar supportive which could well cap Rand strength above 7:$ and make for some weakness towards 8:$ later this year or next.

Still, all performing bits and pieces around the world (US equities, Dollar, commodities, emerging Asia currencies and equities) are heading higher together while risky (European) currency and bond yields are under pressure.

Could that still mean the Rand may firm towards 7:$ or even below this year. Yes, making it advisable to allow for a wide 6.75-8.25:$ range.

Sterling has the advantage of having fallen by a third (likely to invigorate UK manufacturing and exports) while its economic growth outlook should improve, and inflation is bouncy at 3.4%, indicative UK rates won’t remain low for long indefinitely.

In that mix resides a Sterling bottom and renewed cyclical firming. Sterling doesn’t need to lose much further ground and may regain some, suggesting Rand at 10.50-12.00:£, though watch the current bond market unease and its contagion potential.

In contrast, the Euro has only eased by 20% against the Dollar so far. Though the Greek saga is capable of lifting spirits whenever breakthroughs are achieved, the reality seems to be a very patchy fix, with similar problems affecting Portuguese and Spanish fiscal reality.

With Europe having to show it has a mechanism in place to decisively address wider fiscal issues, with many political problems remaining, and the European recovery being less robust than the US, the Euro could well sink further (many targeting 1.30:$, some even opting for distant parity).

That could mean the Rand has some firming potential left against the Euro, potentially 9.25-10.75:€.

On a medium-term view (3-5 years), the European space should be a lot cleaner. Most Southern Europeans will show healthier fiscal conditions. European support (and debt haircuts) will have done much to achieve this, including large sacrifices by the countries concerned.

European growth should by then have improved more. It could well mean some Euro recovery from oversold levels eventually, though respective central bank actions will also be important in pitching the Euro.

It suggests Dollar of 1.20-1.35:€ this year and next, translating into a 9-11:€ range against the Rand.

All these Rand ranges still suggest a measure of Rand overvaluation, varying from modest to severe, fair value for many observers falling somewhere in 8.00-8.50:$ territory, and deteriorating by 5% annually.

Globally, early recovery towards potential growth and closing of output gaps warrants normalization of interest rates (where rates were excessively lowered during the crisis).

But recovering growth and rising interest rates, or the expectation thereof, attracts more incoming capital, pushing currencies stronger and acting as an anti-inflation depressant, supposedly good for the economies so affected (Aussie, Canada, Brazil, Russia, India).

Not everyone wants their currency firming to the point of overvaluation, given the negative impact on growth.

Even so, countries with cyclical deficits need more space to grow out of their problems, so their currencies can weaken, while others better positioned can let their currencies firm, suppressing inflation and boosting their domestic absorption (consumption and investment).

South Africa wouldn’t mind suppressing inflation more but not at the expense of growth. Like other deficit countries, South Africa would presumably prefer a somewhat weaker currency, though not to the point of boosting inflation.

Rand in 7-8:$ territory would probably not support a final interest rate cut, but 6-7:$ could if it is accompanied by long-term inflation falling towards 4% (rather than 5%), core inflation well anchored mid-target range, inflation expectations still easing further and economic recovery erasing the output gap only gradually.

Not all these hurdles may be cleared.

SARB last week hinted at rate pause “for some time”, understandably so, given the many risk factors, prime stuck at 10%.

Source: Cees Bruggemans, FNB, April 28, 2010.

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