The rand: A hopeful portend of better markets to come?

Last week was a better one for the rand. After an extended period of rand weakness that began at the turn of the year, the rand, on a trade weighted basis held its own.

Accordingly the JSE proved to be one of the better emerging equity markets last week (measured in US dollars) though emerging markets again lagged behind the S&P 500 – a trend that has persisted since the beginning of the year. Until the year end the JSE had been an outperforming emerging market during a period when emerging markets had outperformed the S&P 500.

Read the full article including graphs and figures in the Daily View: Daily View 14 February 2011

This trend in favour of developed over emerging markets has clearly been affected by events in Egypt. Egypt, being geographically part of Africa, may have had a disproportionate impact on the African components of the emerging market (EM) Index. However it should be said that the rand, as a very well traded emerging market currency, tends to act as a currency proxy for all EM currencies leading to some relative outperformance in the good times and underperformance when risks are elevating.

We show below how the sovereign risk premium for RSA Yankee Bonds over equivalently long dated US Treasuries (RSA bonds issued in US dollars) increased from a record low premium of 62bps on 21 January to 151bps by Friday 12 February 2011. The increase in the average EM bond spread has been less pronounced – an increase from 221bps in early January to a peak of 271bps at the end of January. This risk premium is currently 251bps over US Treasuries.

However some of the news on the SA risk front has been more encouraging. While RSA rand denominated bond yields have been rising, they have increased by less than their US benchmarks. And so the difference between RSA and US yields, indicating break even exchange rate depreciation, has declined to below 5% pa. This interest spread can be said to represent the total RSA risk premium, that is the extra income received for absorbing rand risk.

A very important indicator for the US and SA is the extra reward bond investors receive for absorbing inflation risk. The difference between the yield on vanilla US Treasury Bonds and their inflation protected equivalents (Tips) is an objective measure of inflationary expectations. Judged by this measure long term inflation expectations in the US remain well contained at around 2% p.a.

The danger remains that unless the US addresses its fiscal deficits and unless the Fed can withdraw all the liquidity it has pumped into the system, inflation will pick up and extra protection for higher expected inflation will become reflected in higher long term Treasury yields. So far so good for the Bernanke Fed, at least in the opinion of Mr/Ms market.

It is of interest to note that while Investment grade corporate bond yields have moved higher in sympathy with Treasury yields, the yields on below investment grade bonds (so called junk bonds) have continued to decline.  Less fear of default, given the improved state of the US economy, has seen a declining risk spread on these bonds offset higher benchmark yields.

The hope for a stronger rand in the weeks to come depends largely on less risk being priced into emerging market equities and bonds. The yields on RSA bonds have been moving up and down quite consistently with net foreign bond purchases. And foreign bond sales rather than net purchases have aided rand weakness in recent weeks. A sense that these yields represent an attractive carry, especially if rand stability can be priced in, would assist the rand as would any renewed appetite for emerging equities.

A degree of tolerance for risk, given the state of the world, seems justified. This view is consistent with commodity price strength and a renewed confidence in emerging markets and their economic management. Expecting rand stability or even a degree of rand strength in such circumstances, not rand weakness, seems consistent also.