Rand strength surprise

July 19th, 2017 by Brian Kantor

A shorter version of the below article was published in the Business Day – Available here

The rand does not always perform as expected, thanks to the US dollar, to which we should always pay close attention

Rand strength almost always surprises the market. The large spread between SA interest rates and US or other developed market interest rates indicates that the market expects the rand to weaken consistently against the US dollar and other developed market currencies. By the close on 18 July this spread for 10 year money was 6.43%. To put it another way, the rand was expected at that point to lose its exchange value in US dollar at the average annual rate of 6.43% over the next 10 years.

This difference, or interest carry, is also by definition the annual cost of a US dollar or euro to be delivered in the future. And so, the forward rate of exchange for the USD/ZAR to be delivered in a year or more always stands at a premium to the spot rate. This year, the daily interest spread on a 10 year government bond has varied between 6.4 and 5.94 percentage points while the USD/ZAR has varied between a most expensive R13.20 to a best of R12.42, using daily close rates of exchange. It should be noticed in figure 1, that while the interest spread- or expected exchange rate has a narrow range – the two series move together. That is a stronger rand leads to less rand weakness expected (less of a spread) and vice-versa.

Another way of putting this point is that the weaker the rand the more it is expected to weaken further and vice versa. This is not an intuitively obvious outcome. Normally the more some good or service falls in price the more, not less attractive it becomes to buyers. This is the case with developed market exchange rates – dollar strength vs the euro tends to narrow the carry. But this is not the case with the rand exchange rate and perhaps also other emerging market exchange rates. For the USD/ZAR exchange rate, rand weakness is associated consistently with still more weakness expected and vice versa as figure 1 and 2 indicates. It would seemingly therefore take an extended period of rand strength to improve the outlook, as indeed was the case between 2003 and 2006 when the spread narrowed to about 2% with significant rand strength (See figure 2).


While a more favourable direction for the USD/ZAR may well come as a surprise – the explanation of rand strength or weakness should be more obvious than it appears to be, judged by much of the commentary offered on changes in the exchange value of the rand. The reality demonstrated below is that the behaviour of the USD/ZAR exchange rate to date has had much less to do with South African events and political developments and much more to do with global forces than is usually appreciated. And such global forces affect the exchange value of the rand and other emerging market currencies in similar ways.

Unless the future of SA economic policy is very different from the past, this is still likely to still be the case in the months ahead. In other words, rand strength or weakness in the months ahead, will have a great deal more to do with what happens to the US economy and the strength or weakness of the US dollar against other major currencies, than political and economic developments in SA. Predicting the USD/ZAR accurately therefore will require an accurate forecast of the US dollar vs mostly the euro, and also to a lesser extent the yen, the Swiss franc, the Swedish kroner and the Canadian dollar.

We show below in figures 3 and 4 below how the USD/ZAR exchange rate moves closely in line with those of other emerging market (EM) currencies. Furthermore it is also shown how all EM currencies strengthen when the USD weakens against other major currencies and vice versa. That is US dollar strength vs its peers is strongly associated with EM exchange rate weakness generally and so also USD/ZAR weakness.

In the correlation matrix below, using daily data from 2012, it may be seen that the correlation between the trade weighted US dollar vs developed currencies, and the JP Morgan Index of emerging market currencies is a high and negative (-0.82) (dollar strength = emerging market weakness) The correlation of the US dollar with our own emerging market nine currency basket (US dollar/EM) that excludes the rand, is even greater at ( 0.98) The correlation of daily exchange rates between the USD/ZAR and the trade-weighted dollar index is (0.89). In other words, the stronger the trade-weighted dollar, the higher its numerical value, the more expensive the US dollar has become. As may also be seen in the table below, the correlation between the USD/EM nine currency basket and the USD/ZAR is also very high (0.95).

These relationships are also indicated in figures 3 and 4 below. In these charts the trade-weighted dollar in these figures is inverted for ease of comparison – higher values indicate weakness and lower values strength. It may be seen that US dollar strength after 2014 was closely associated with emerging market and rand weakness. Very recently, since June 2017, it is shown how a small degree of US dollar weakness has been associated with emerging market and rand strength.


In figure 4 below we show the ratio of the USD/ZAR to our Investec nine currency basket (USD/EM) since 2012. This ratio (2012=1) widened sharply after President Jacob Zuma sacked Minister Finance Nhlanhla Nene, only bring in Pravin Ghordan a few days later. This ratio then narrowed sharply after the second quarter of 2016, indicating much less SA-specific risk was gradually being priced into the rand.

(The nine currencies: Equally weighted Turkish lira, Russian ruble, Hungarian forint, Brazilian real, Mexican, Chilean and Philippine pesos, Indian rupee and Malaysian ringgit.)

The second Zuma intervention in March 2017, when Gordhan was in turn sacked by Zuma, had less of an impact on the relative value of the rand. In figure 5 below, we show a close up of this ratio in June and July 2017 after the independence of the SA Reserve Bank was called into question by the SA Public Protector, Busisiwe Mkhwebane. The ratio initially widened on the statement by the Public Protector, to indicate more SA risk.  But the rand and its emerging market peers both strengthened as a result of a degree of US dollar weakness against the other major currencies, as is shown in figures 5 and 6 below.

Given the history of the USD/ZAR it should be appreciated that betting against the rand at current rates is also mostly a bet on the value of the US dollar vs the euro and other developed market currencies. Hence the causes of dollar strength or weakness needs careful consideration. The US dollar strengthens US growth beats expectations, leading to higher interest rates in the US relative to growth and interest rates in the likes of the Eurozone as well as to US dollar strength. Emerging market currencies and the rand can be expected to weaken in this scenario. A weaker US dollar and stronger euro will tend to have the opposite effect, as we have seen recently.

Relatively slower US growth and a more dovish Fed can be very helpful to emerging market exchange rates (like the rand) over the next few months. This is providing the political economy of SA is not to be radically transformed. The financial markets, judged by the ZAR/EM exchange rate ratio and the yield spreads, are currently strongly demonstrating a belief in policy continuity in SA. 19 July 2017