Things became more active on the global interest rate front last week, led by an advance of US yields. The key 10-year US Treasury yield was below 3% earlier in the week, but was at 3.12% onThursday before pulling back to 3.05% on Friday (it was ar 3.07% this morning). Not only have yields moved higher, but the spread between US Treasury and German Bund yields have widened further, to 2.5%.
This may be thought to be enough of a carry (enough US dollar weakness priced in, that is) to attract funds to the US and restrain the upward march in US rates and the US dollar. The US dollar has gained not only against the euro and other developed market currencies, it has gained against emerging market (EM) currencies, like the rand, as is usual when the dollar rises against the euro, yen and sterling. A strong dollar is a particular threat to EM currencies. The JP Morgan EM exchange rate index is now at 66.1 while the the US vs developed market currencies index (DXY) is trading at 93.87.
The rand has been among the better EM performers in the face of the advancing dollar as we show in figures 4 and 5 below (all rates in these charts up to 18 May – though the rand did come under motre pressure than other EM currencies on Friday). The ratio of the USD/ZAR to our own construct of eight other EM currencies and their exchange rates with the US dollar, improved significantly between November 2017 and March 2018 and the USD/ZAR has maintained its rating since then. The story of the rand has once more become a story of the US dollar rather than of South African politics. And seems very likely to remain so.
This ratio was 0.917 on the Monday 14 May – it weakened to 0.934 by the Friday. The story of the rand has once more become a story of the US dollar rather than of South African politics, and seems very likely to remain so.
Interest rates in the US have risen (and the dollar has strengthened) because the acceleration in US growth has been confirmed by recent labour market trends and by the strength in retail sales volumes reported last week. The state of economies outside the US, in Europe and even in emerging markets however, appears less certain. Global growth appears, at least for now, less synchronised – making for fewer correlated movements in short- and long-term interest rates.
It is of interest to note that US shorter term interest rates have been rising faster than long rates. The spread between the 10 and two-year Treasury bond yields have narrowed further. This flatter yield curve indicates that the US may be getting closer to the end of the cycle of rising short rates. Or in other words the GDP growth rates that justify higher short rates may well have peaked and are slowing down- which if so will cause short rates to decline from higher levels in the not too distant future. (See figure 6 below)
It is of particular importance to note that the recent increase in US yields have not been a response to more inflation expected. Inflation-protected real yields offered by the Treasury (TIPS) have increased in line with vanilla bond yields. The spread between nominal and real 10-year treasury yields has remained largely unchanged around 2.2%. That is to say, the bond market continues to expect inflation to remain at the 2% level for the next 10 years. So what is driving nominal yields higher is more growth, rather than the expectation of more inflation, thus representing interest rate developments that are less dangerous to equity valuations than if it were only inflationary expectations that were driving yields higher. The more GDP (and so earnings growth) expected, the more it improves the numerator of any present value calculation, perhaps enough to compensate for higher discount rates.
South African bond yields, as well as the USD/ZAR, have moved higher in response to US yields. However the spread between RSA and Treasury yields has remained largely unchanged. The spread, which indicates by how much the rand is expected to weaken against the US dollar over the years, narrowed sharply after November 2017. In other words, as the political news out of South Africa improved. Figure 8 below shows the SA exchange rate risks and the more favourable trends in RSA and US long bond yields, and in exchange rate expectations since January 2017.
Conclusion: how best to react to dollar strength
A stronger US dollar is seldom good news for the growth prospects of emerging market economies, including South Africa. It puts upward pressure on prices and downward pressure on spending. It furthermore raises the danger of monetary policy errors of the kind Argentina has been making: raising interest rates to fight exchange rate weakness and the (temporarily) higher prices that follow. This then slows down economic growth further, without helping and maybe even harming the exchange rate. Slower growth drives capital away and interest rates, become less attractive when a still weaker exchange rate is expected.
The wise policy approach is to ignore of exchange rate weakness that is caused by dollar strength and not by excessive domestic spending. South Africa made such monetary policy errors during the last period of US dollar strength between 2011 and 2016. We may hope that such errors are not repeated. We may hope even that this period of dollar and US strength is a temporary one – and that growth outside the US resumes an upward trajectory. 21 May 2018