Macro Analysis /
Global

FOMC rate decision to steal the show, East African countries ramp up spending

  • Forex: Emerging market currencies remain near a one-month low amid persistent dollar strength

  • Fixed Income: Federal Reserve expected to deliver a hefty rate hike this evening to fight inflation

  • Macroeconomic: East African countries ramp up fiscal expenditure to shore up economic growth

Kieran Siney
Kieran Siney

Head of African Markets

Takudzwa Ndawona
Takudzwa Ndawona

Financial Markets Analyst

ETM Analytics
15 June 2022
Published by

GLOBAL

The big day is upon us. The direction of the USD and currency markets will depend on tonight’s FOMC rate decision and the forward guidance provided in the policy statement. While the trade-weighted USD has gapped lower this morning, the broader bias in the greenback remains firmly to the topside. The DXY closed yesterday’s session at a fresh multi-decade high as the market continues to price for a more aggressive shift in policy from the Fed and wider monetary policy differentials between the US and other major economies. The base case is for the dollar strength to persist in the near term. The risk however is that the Fed comes out less hawkish than the market is pricing for, which given how much rate hike risk is priced in and how overvalued the USD is, could prompt a significant correction lower in the greenback. Given how much is riding on the outcome of the FOMC meeting, we expect trade conditions to be thin today until the rate decision is announced.

AFRICA

Namibia: The Bank of Namibia is set to deliver its latest verdict on its key interest rate today. At the meeting in April, the BoN lifted its key rate for the second consecutive time to safeguard its currency peg with South Africa’s rand and help counter inflationary pressures stemming from the war in Ukraine. The BoN is once again expected to raise the key rate in a bid to contain inflation which continues to rise and sustain economic growth. It is worth pointing out that Namibia forms part of a common monetary area with South Africa, with the rand legal tender and monetary policy and foreign exchange rules often guided by the SARB’s actions. Therefore, the risk exists for a 50bps rate hike today.

Ethiopia: As part of further efforts to improve the humanitarian situation on the ground and pave the way for the resolution of conflict in northern Ethiopia, PM Abiy Ahmed yesterday announced that the federal government had formed a committee to negotiate with the northern Tigray region’s forces. The Deputy Prime Minister will lead the committee, which will have around 10-15 days to work on the finer details of what will be negotiated, according to Ahmed. The war in the northern region has hindered government plans to modernise the economy and deterred foreign direct investment.

South Africa: The World Bank yesterday approved a EUR454.4m (R7.6bn) loan to South Africa for the country’s COVID-19 Emergency Response Projects. The approval of the funds comes after a request by the SA government for assistance in financing vaccine procurement contracts. The World Bank noted that supporting the country’s coronavirus vaccination program will help the government better cope with the pandemic and create the fiscal space needed to strengthen its health system and ensure financial and institutional stability. The World Bank’s loan will help reinforce efforts by the government to support COVID-19 vaccination as the spread of the virus continues to pose a threat to South Africa. Given that this is a low-interest loan, it does not pose significant pressure on the government fiscus, which is already burdened by the high contingent liabilities and a shrinking tax base.

Tanzania: Fiance Minister Mwigulu Nchemba yesterday cut Tanzania’s growth forecast for 2022. The Tanzanian economy is now forecast to expand by 4.7% this year versus November’s estimate of 5.2%. Growth is, however, expected to pick up in 2023, coming in at 5.3%. Nchemba added that the projected economic expansion would be supported by projects including 970km of standard gauge railway, three hydroelectric plants with a total of 2,695 megawatts of capacity, and the construction of more than 2,500km of road. Tanzania’s economy is recovering from the coronavirus pandemic, which negatively impacted sectors like tourism. The recovery has, however, been affected by the war in Ukraine, which has sent prices for commodities such as wheat and oil soaring.

Uganda: As it tries to drive an economic recovery from the coronavirus pandemic, Uganda plans to spend UGX 48.1trn ($12.38bn) in the fiscal year starting in July, 7% higher than the current year. A larger projected increase in budget and grant revenue is, however, to result in a smaller deficit of 5.4% of GDP in the 2022/23 fiscal year, down from 7.3% of GDP in 2021/22. Meanwhile, Uganda plans to borrow around UGX 5trn ($1.3bn) from domestic markets and UGX 4.7trn from external markets. Given the tightening of global financial conditions, it remains to be seen whether Uganda will be successful in borrowing externally.

Zambia: Finance Minister Situmbeko Musokotwane yesterday said that a deal between the IMF and Zambia at the of June is unlikely, citing a slight delay. Musokotwane, however, indicated that Zambia will on Thursday virtually attend the meeting of its creditors' committee in Paris, where the government will present its economic reform agenda and progress made since reaching a staff-level-agreement with the IMF in December. Musokotwane added that Zambia will also present a plan to achieve debt sustainability and the support it will require from creditors including initial assurance of debt treatment. Zambia needs financing assurances from official creditors to secure approval from the IMF board for a $1.4bn bailout package, and although the government is set to miss its end-of-June target, the talks are a step in the right direction.

Forex: Emerging market currencies remain near a one-month low amid persistent dollar strength

The trade-weighted DXY remained on the front foot yesterday, extending its gains to a fifth straight session to close at a multi-year high, supported by expectations of sharper Federal Reserve interest-rate hikes to fight inflation. The Federal Reserve will today most likely hike by 50bp and then suggest that another rate hike is coming at the next meeting. Powel will probably be non-committal to moves beyond that, but last week's inflation surprise suggests that there is an outside risk that he could flag another big move for the September meeting. There will be new forecasts which suggest upward revisions to inflation but possibly lower revisions to the growth estimates.

Given that the market is increasingly pricing in more aggressive Federal Reserve hikes with some even pointing to a 75bps hike and the rising probability of a US recession, a cautious bias has permeated the EM FX space, with currencies broadly weakening. For context, the MSCI EM FX index, which we use as a proxy for the performance of emerging market currencies, remained unchanged at an almost one-month low yesterday and has lost almost 2% since the beginning of the month. On a year-to-date basis, the index has lost around 3.67%, while the USD has rallied by over 10%. Concerns about slowing economic growth in China due to numerous coronavirus lockdowns and the war in Ukraine are some of the other factors that have hurt emerging markets.

Looking ahead, we see further downside risks for EM and frontier market currencies in the near term, especially for those with weak fundamentals, as risks of capital outflows heighten further. The outlook for African FX is mixed. Country’s benefitting from high international commodity prices are expected to be more resilient to the gloomy external conditions.

Fixed Income: Federal Reserve expected to deliver a hefty rate hike this evening to fight inflation

All eyes are on are tonight’s FOMC rate decision. Heading into the meeting, markets are pricing in a 75bps rate hike as policymakers try to rein in rampant inflation. The professional market aggressively scaled up bets for an outsized rate hike after the May US CPI print beat expectations on Friday, coming in at a 40-year high of 8.6% y/y.

The aggressive shift in rate hike expectations has triggered a fresh bout of selling pressure across bond and swap markets around the world as traders price in the risk of higher interest rates and the adverse impact of higher lending costs on the fiscal position of countries. In addition, bets for a more hawkish Fed have fueled risk-off conditions. US Treasury yields have spiked in June, with yields across the curve reaching fresh multi-year highs. 

Emerging and frontier market bonds have also sold off sharply this month. The JP Morgan EMBI Global Total Return Index, which we use as a proxy for the performance of emerging market bonds, has lost 3.09% over the past three sessions as bond yields surged. African bonds have not been spared, with the Bloomberg African Bond Index shedding 3.24% over the same period. On a year-to-date basis, emerging market bonds have lost more than 18%, while African bonds are down by almost 6%.

While the headwinds for bond markets the world over are expected to persist in the near term as central banks and investors continue to underestimate how strong and persistent inflation is, we see a light at the end of the tunnel for bond markets. After ramping up bets on steeper Fed hikes, traders are now turning to when the policymakers in the US will need to cut interest rates as recession fears mount.

While money markets are pricing in two subsequent 75bps rate hikes for June and July and more rate hikes in the coming months, traders are also now pricing in three 25bps rate cuts within two years. There is a strong probability that the Fed over-tightens as it looks to get a hold on inflation and then has to unwind rates late next year as growth risk continues to rise. The market is pricing in one 25bps cut for late 2023, followed by a further 50bps worth of rate cuts by the middle of 2024.

This presents a great buying opportunity for bond traders in the months ahead. Traders can take advantage of the attractive valuations on offer before the tide turns and the market focuses on recession risks. Moreover, we expect global supply chain pressures to ease next year, which should help ease inflation pressures. This comes against the backdrop of high base effects, underpinning the notion that rate cuts are very likely in 2023.

For now though, we expect the broad-based sell-off in bonds to continue as the Fed continues its fight against persistent inflation. That said, the risk heading into tonight’s FOMC meeting is, given the current aggressive market pricing, that the Fed is deemed not hawkish enough. This would likely result in a correction in bond yields and the USD.

Macroeconomic: East African countries ramp up fiscal expenditure to shore up economic growth

East Africa is facing its second economic shock in as many years as the fallout from Russia’s invasion of Ukraine continues. Surging import prices, particularly food, fertiliser and energy, together with a sharp decline in tourists from the two countries, have weighed heavily on the economic performance of countries in East Africa. This comes against the backdrop of a devastating drought that hit the region, political disruptions, mounting inflation pressures, broad-based currency weakness and increased fiscal risks.

Soaring international commodity prices have resulted in a deterioration in regional trade dynamics and increased dollar demand from importers. As such, regional currencies, for the most part, have come under considerable selling pressure this year. The most notable losses have been in the Ugandan shilling and the Ethiopian birr, which have both lost more than 5% against the USD since the start of the year. The currency depreciation is compounding inflation pressures and adding to growth headwinds.

To cushion the blow of the external economic shocks, East African governments have ramped up expenditure to sustain economic growth in their respective economies. This was evident in the two budget speeches yesterday. Tanzania and Uganda announced that they would increase expenditure to shore up their economies. Tanzania sees spending rising by 9% in the 2022/23 budget to TZS 41.48trn or $17.84bn. Uganda meanwhile plans to spend UGX 48.1trn in the 2022/23 fiscal year starting next month, a more than 7% increase.

This means that six of East Africa’s governments increased spending plans for the 2022/23 fiscal year as they look to drive economic growth. In addition to the increased fiscal expenditure, Kenya and Tanzania have imposed measures to ease the cost of living expenses for households, which include subsidies on items such as fuel. Uganda meanwhile has ruled out subsidies due to limited fiscal room but has joined Kenya in raising interest rates in a bid to rein in inflation.

Central banks in East Africa are having to play a fine balancing act of curtailing inflation without choking off their respective economies as global growth risks continue to mount. While inflation in Tanzania remains contained, we expect consumer price growth to accelerate in the months ahead, which could prompt a more hawkish shift from the Bank of Tanzania, especially as the Federal Reserve continues to hike rates aggressively. East African central banks will want to keep their respective monetary policy differentials with the US intact to ensure that some degree of financial market stability remains.

In conclusion, while external headwinds continue to run hot, economic growth in East Africa is expected to remain solid in the upcoming fiscal year starting in July, fueled by increased government spending. That said, the increased spending together with higher debt servicing costs as interest rates around the world continue to rise means that fiscal risks in the region will intensify. Inflation risks over the next 6-10 months are acute, and as such, we expect central banks in the region to turn more hawkish and tighten monetary policy further. From a currency perspective, we expect the broader bearish bias seen in the first half of the year to persist in the remaining months of 2022.