The Rand in the rocky credit markets The economic calendar is wild this week so I thought it would be best to do a deep fundamental dive into the USDZAR . All the attention will be on the Federal reserve tomorrow and whether or when they will pause their rate hikes. We need to look past the hype around the interest rate and the “pivot" narrative. Focus should however be on how the markets will cope with the Fed’s liquidity drain and how it will impact the future price of money ( ie . Interest rates).
Before we kick-off, correlation does not imply causation...
I’ll start by explaining the chart you’re looking at. What you’re seeing is the positive correlation between the USDZAR and the difference between the South African government bond 10-year yield (ZA10Y) and the US 10-year treasury yield (US10Y). The interest rate differential is referred to as the carry trade potential. Investors can borrow money on the cheap from developed low-risk markets and invest the borrowed money in riskier destinations to earn more interest. The interest rate difference is then pocketed by the investor. The preferred vehicle to capitalise on the interest rate differentials between two locations are government bonds (they are low risk and liquid).
The reason for the positive correlation between the USDZAR and the bond yield differential is because when there is risk-on sentiment in the market, investors tend to move funds out of the safety of US treasuries and into riskier assets. The sell-off in US treasuries causes US10Y yields to rise (decreasing the bond yield differential), and the rand tends to appreciate in risk-on phases of the market, citrus paribus. (Decreasing bond yield differential; USDZAR decrease due to rand appreciation). Conversely, when investors are risk-off they run to the safety of US treasuries. The buying of US-treasuries lowers the US10-year yield which increases our bond yield differential. We all know how rapidly the rand can depreciate in risk-off phases when the liquidity wave pulls back to the US, leaving the rand on the rocky shore. (Increasing bond yield differential; USDZAR increases). Our strong correlation however weakened in August 2022 when the US 10-year yield rocketed higher after the Fed started their hiking cycle.
Let’s zoom in on the Fed since its Fed week. The most important chart in the market , the Fed’s balance sheet: www.federalreserve.gov .
The Fed has so far tapered roughly 5.52% off its balance sheet since April 2022. The Fed is selling treasuries to taper its balance sheet and to soak up liquidity from the market (if there will be enough buyers, only time will tell). This is rand negative.
Now let’s get to where all this week’s focus will be, the Fed’s interest rate decision. The Fed is expected to slow its rate hikes to 25bps this week and push rates from 4.50% to 4.75%. The Fed tends to follow the US02-year yield (US02Y) as guidance on its interest rates and it seems as if the US02-year yield has topped out between 4.75% and 5.00%. The Fed pause seems near, and the latest inflation figures from the US supports the narrative that the Fed has managed to cool inflation.
The most concerning thing in the market currently is the inverted yield curve:
History doesn’t repeat itself, but it rhymes. For the Fed to normalise the credit markets it will have to pause rates. That is usually when something the market breaks and the Fed is forced to cut rates and inject liquidity into the markets. When the Fed pushes easy money ( QE or whatever buzz phrase they'll use) into the market investors rotate from longer dated bonds to shorter dated bonds. To conclude, if and when the Fed pauses its rate hikes, the US10-year yield will melt higher which could be rand positive based off our correlation analysis. Just have popcorn (and gold , silver and other real assets) ready for when the Fed is forced to cut rates/ pivot because that will be caused by arguably the biggest credit market implosion in the history of fiat money.
To end off I leave you with the words of Zoltan Pozsar: "commodities are collateral, and collateral is money."
