/ 14 March 2023

Explainer: What a weak rand means for interest rates

Reserve Bank
Inflation ticked up within a hair's breadth of the South Africa Reserve Bank’s upper limit in October, suggesting there could still be interest rate hikes down the line, even if monetary policymakers keep them on hold as expected this week.

The rand lost its footing again last week, freefalling to a two-year low, reaching R18.73 to the dollar. Though the domestic currency has since managed to retrace some ground, thanks to recent turmoil in the US banking sector, it continues to be underpinned by weakness.

The rand’s performance will factor into the South African Reserve Bank’s decision-making later in the month, when the monetary policy committee will be weighing up how big a repo rate hike the economy can endure. 

After the bank raised the repo rate by 25 basis points in January, the cost of borrowing is already 75 basis points higher than it was before the pandemic. The higher cost of borrowing threatens to crush the country’s already anaemic economic growth.

So why has the rand struggled to muster some strength? The easy answer is that the currency’s value has been undercut by South Africa’s deteriorating economic conditions.

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The country’s economy is expected to record meagre growth in 2023, largely because of the severity of the ongoing energy crisis. Last week’s GDP figures, which revealed that the economy contracted by a deeper-than-expected 1.3% in the fourth quarter of 2022, supported the view that the country is heading towards another technical recession.

Ratings agencies have flagged South Africa’s low growth potential as a key credit weakness. Last week, S&P Global unexpectedly downgraded the country’s credit outlook from positive to stable, citing the economic impact of load-shedding. Worsening economic conditions mean that South Africa’s efforts to claw back its investment grade ratings will be more arduous.

But there is another reason for the rand’s weakness — the dollar’s strength, which was recently bolstered by hints that interest rates in the US would peak at a higher level than previously expected. This is after Federal Reserve chair Jerome Powell signalled as much, citing stronger economic data and stickier inflation stateside. 

Higher interest rates mean higher yields for investors, thus attracting foreign capital. As the demand for the dollar increases, its value goes up. Last year, the two-year treasury yield rose above 5% for the first time since 2007.

Last week, Investec chief economist Annabel Bishop noted that comparatively low interest rates in South Africa, and high inflation, have reduced real returns, disincentivising investors. The slower pace of rate hikes compared to the US, she noted, has reduced the risk premium offered to investors. 

“The high-risk nature of SA as an investment destination means interest rates must be higher in SA than in the US. Lowering the difference between SA and US interest rates simply weakens the rand, in turn placing upwards pressure on inflation,” Bishop explained.

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The Reserve Bank’s monetary policy committee, Bishop said, is likely to follow the Federal Open Market Committee (FOMC), hiking as the US does by either 25 or 50 basis points. However, neither will repair the interest rate differential between South Africa and US and so will not prompt substantial rand strength.

The FOMC will deliver its decision next week and the Reserve Bank on the last Thursday of the month. US inflation data, released on Tuesday, will factor into the FOMC’s decision. 

Meanwhile, recent ructions in the US banking sector could also influence how the Fed moves next week.

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Indeed, analysts at Goldman Sachs on Monday reportedly revised their forecast for the upcoming FOMC meeting, saying they no longer expect the Fed to hike interest rates after the collapse of Silicon Valley Bank. The tech-focused lender’s crash, brought on in part by the rapid rise of US interest rates, caused investors to flee banking shares. 

Tumbling bank stocks could well lower the Fed’s appetite to hike rates and the dollar has slid on speculation to this effect, buoying the rand.