South African Rand: What is the possible new normal?

The rand has come up against both global and local challenges over the course of the year.

Looking back, uncertainty reigned around South Africa’s general elections, which was paired with bad news from rating agencies, a poor first quarter GDP print and continued concerns around the SOEs’ funding needs. As if things were not bad enough at home, global factors such as the US-China trade war escalations and the global growth slowdown hit the high beta-currency hard.

Between 23 July and 14 August, USD/ZAR moved from the 13.90 level to 15.40. A R1.50 move based on an influx of both economic and political news presents a question: are current levels above 15.00 the new normal for the exchange rate?

In answering this question, we consider the rand’s real effective exchange rate (REER), which is the nominal effective exchange rate adjusted by the effective foreign price ratio. The REER is obtained by weighting the exchange rate between the rand and currencies of South Africa’s major trading partners – using each country’s share in South Africa’s total foreign trade as weights.

If we use the long-term REER average starting from 2000 to infer strength or weakness, we find that the currency is 10.7% undervalued. When using the post-GFC (global financial crisis) REER average of 112.6, the rate is 6.3% undervalued (Figure 1). Applying both these levels of undervaluation to the exchange rate 15.42 (end of day figure for 14 August), the implied USD/ZAR fair value is 13.76 using the REER’s long-term average and 14.44 using the post-GFC average.

Even though these values point in the direction of rand appreciation, rand volatility cannot be disregarded.

What characterises the rand?

The rand forms part of the emerging markets currency complex. It makes sense then to compare it to its peers to find clues as to whether it is being steered predominantly by global or local factors. When looking at JP Morgan’s EM currency Index over the course of this year, we see that the rand has underperformed significantly (Figure 2). You could argue that the catalyst for weakness has been a combination of global and domestic  factors. Yet, the extent of depreciation suggests that the underperformance experienced relative to the EM basket can be explained by more than just the ongoing trade war and global growth slowdown, and has been exaggerated by local factors such as weak economic data and challenges to structural reform. This could explain why the rand has broken through a number of resistance levels (Figure 3) this year resulting in the growing likelihood of USD/ZAR15.00 becoming the new normal.

Rand volatility cannot be overlooked

The rand is a high-beta currency, therefore it is an important exercise to analyse the currency’s volatility. Realised volatility (the actual movement in USD/ZAR over a specific past period) tends to track the implied volatility (current market price for volatility) quite closely. Since 13 August, higher realised 6-month volatility was recorded (Figure 4). After trending lower at the start of 2019, the 6-month implied volatility began to rise at the start of August. This infers that the market expects the exchange rate’s volatility to increase further. In many cases, the rand’s volatility when it depreciates tends to be higher than when it strengthens.

This is best represented if we take the rand’s daily moves since the start of 2014 and look at the annualised standard deviation for all points highlighting rand weakness and all the points showing rand strength. The annualised standard deviation for the currency’s weakness was more than that of rand appreciation, which confirms that volatility is greater when the rand is depreciating.

A possible new normal

Even if the local currency possibly steps up to a new normal above 15.00 (Figure 5), we should be mindful that the volatile currency can move below this level during periods of risk-on. A likely trading range over the next six months is 14.20-15.50 – bearing in mind that spikes and slight breaches of these bounds are a given with normalisation within the bounds occurring relatively quickly. We expect the rand to end 2019 at 15.00. Despite the expectation of sizeable moves, we believe the balance of risks and the skew in rand movements will be to the upper-end of the range.

Strength will, however, be hard won with myriad local factors to contend with. Eskom’s funding woes and pressure on the fiscus remain concerns. Moody’s will decide the sovereign’s fate in November and, although a downgrade to sub-investment grade may already be priced in, spikes on the back of actual event outcomes are to be expected. Over the next six months, the global environment will play a significant role in steering the rand. Persistent uncertainty over trade tensions and expectations of further global monetary policy easing in response to slowing growth will be the main factors swaying the risk environment.

Contributor’s Profile:

Varushka Singh is a Fixed Income and Currencies Strategist and is part of RMB’s Global Markets Research team. She has been a research analyst for 7 years. During this time the asset classes she has covered include currencies, corporate credit and fixed income; servicing institutional clients in South Africa, US and Europe. She holds an Honours degree in Advanced Mathematics of Finance from the University of the Witwatersrand and a BSc degree in Actuarial Science from the University of KwaZulu-Natal.