Traders Brace for Long War With Inflation: South Africa Credit
South Africa’s first interest-rate increase in five years is persuading traders that central bank Governor Gill Marcus will be unmoved by slowing economic growth and rising political pressure in her quest to conquer inflation.
Forward-rate agreements, used to lock in borrowing costs, are signaling a further 240 basis points of rate increases over the next year. Similar contracts in Turkey, whose central bank also raised rates last week, show another 24 basis points. The difference in yield between two- and 12-year rand securities shrank 27 basis points since Marcus unexpectedly lifted the central bank’s policy rate by half a percentage point to 5.50 percent on Jan. 29.
With elections looming and the economy struggling to recover from the slowest growth since the 2009 recession, Marcus, 64, was facing pressure from the ruling African National Congress’ labor-union allies to keep borrowing costs at a three-decade low. Instead, she reiterated that the central bank’s primary role is to ensure price stability as the rand’s swoon this year sends inflation toward the upper end of her 3 percent to 6 percent target.
“It has done the bank’s credibility a lot of good,” Rian le Roux, chief economist at Old Mutual Investment Group, South Africa’s biggest private investor, said by phone from Cape Town on Jan. 31. “It demonstrated that if inflation pressures build they will take their eyes off weak growth and focus on the inflation target. History tells you they won’t only hike once.”
With one exception, every rate increase by the South African central bank since 1998, when Bloomberg started compiling the data, signaled the start of a tightening cycle. The anomaly was in October 2000, when then-Governor Tito Mboweni lifted the repo rate by 25 basis points and then cut it by 100 basis points the next June.
Forward-rate agreements starting in 12 months soared 103 basis points after the rate increase to 8.09 percent on Jan. 31, the highest level since November 2008 on a closing basis. The contracts yielded 7.99 percent by 11:40 a.m. in Johannesburg, compared with the three-month Johannesburg Interbank Agreed Rate of 5.68 percent.
The Reserve Bank had kept its repurchase rate steady since a surprise 50 basis-point cut in July 2012 to support an economy that’s been buffeted by slower global demand and mining strikes. Those concerns are being overshadowed by a weaker rand, which is raising the cost of imports such as oil and food.
The rand strengthened 0.3 percent to 11.0887 per dollar by 11:40 a.m. in Johannesburg. Yields on benchmark rand bonds due December 2026 dropped six basis points, or 0.06 percentage point, to 8.87 percent after climbing to 8.93 percent on Jan. 31, the highest since March 2011.
Inflation accelerated in December for the first time in four months, to 5.4 percent. The rate will probably breach the upper end of the target in the second quarter, and average 6.3 percent in 2014, Marcus said Jan. 29. That’s up from a previous estimate of 5.7 percent.
Turkey’s central bank unexpectedly raised its one-week repurchase rate on Jan. 28 by 5.5 percentage points to 10 percent. India also surprised by increasing its key rate the previous day to 8 percent from 7.75 percent, while Brazil has boosted rates for six straight meetings.
South Africa’s rate increase wasn’t aimed at supporting the rand, though the currency’s weakness is the primary risk to inflation, Marcus said. According to the bank’s model, the inflation rate should rise two basis points for every 1 percent drop in the rand. The pass-through has been more muted than that due to weak economic growth, she said.
The central bank cut its 2014 economic growth forecast to 2.8 percent from 3 percent. The forecast for next year was reduced to 3.3 percent from 3.4 percent.
While growth is a concern, “the primary responsibility of the bank is to keep inflation under control and ensure that inflation expectations remain well anchored,” Marcus said.
The rand has slumped amid a selloff in bonds sparked by the Federal Reserve’s tapering of stimulus. Foreign investors dumped a net 21 billion rand ($1.9 billion) of South African bonds this year after annual inflows in the previous five years. The nation needs about 19 billion rand of foreign investment a month to finance its current-account deficit, which swelled to 6.8 percent of gross domestic product in the third quarter.
While the central bank doesn’t directly target the level of the rand, raising interest rates at a time the currency is weakening creates a perception it has shifted focus, said Gina Schoeman, a Johannesburg-based economist at Citigroup Inc. Higher borrowing costs may be ineffective in slowing price increases, she said.
“They have changed their tune,” Schoeman said by phone on Jan. 31. “They have always have been a bank that targets inflation expectations, but now they are far more cognizant of the currency.”
South African President Jacob Zuma has to call a general election before the end of July. With the ruling ANC’s support waning amid voter disenchantment because of 25 percent unemployment and a series of corruption scandals, the risk of a “populist backlash” that would trigger another round of credit rating cuts is rising, Schoeman said in a note Jan. 16.
The Congress of South African Trade Unions, the country’s biggest labor-union federation and a supporter of the ANC, has said it opposes inflation targeting and has called for a weaker rand and lower rates to stimulate growth.
Moody’s Investors Service downgraded South Africa’s credit rating in September 2012 to Baa1, the third-lowest investment grade, on par with Russia and Mexico. Fitch Ratings and Standard & Poor’s followed. Moody’s and S&P both have South Africa on a negative outlook.
Last week’s rate increase shows Marcus won’t cave in to populist pressures, said Peter Attard Montalto, a London-based emerging-markets economist at Nomura International Plc.
“Many market participants thought the MPC was so focused on politics that it would not be able to hike this year,” Montalto said in an e-mail on Jan. 29. “This move considerably increases the MPC’s credibility. The Reserve Bank is indeed orthodox and conservative.”
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