Fixed Income Analysis /

Traders wary of turning less hawkish on the SARB

  • Market has frontloaded its interest rate hike expectations

  • South Africa's growth outlook means that the SARB cannot maintain its current pace of tightening

  • Rates look attractive to receivers at current levels as a result

Daron Hendricks
Daron Hendricks

Financial Market Analyst

ETM Analytics
31 August 2022
Published byETM Analytics

Long before the South African Reserve Bank (SARB) started to raise its key interest rate in November 2021, SA's financial market had moved to position for aggressive hikes at the turn of the new year. In effect, the market was front-loading its interest rate hike expectations well ahead of SARB's tightening cycle. Since the first rate hike in November, the central bank has delivered 200bps worth of rate hikes with the purpose of protecting the South African Rand (ZAR) from capital outflows whilst anchoring inflation expectations. Last month the SARB announced its biggest increase in borrowing costs in 20 years by opting for a 75bps increase while signalling further aggressive monetary tightening ahead to rein in surging inflation. This increased the Repo Rate to 5.50%, approaching the Q4 average interest rate estimate of 5.61% implied by the SARB's Quarterly Projection Model (QPM). Keep in mind that there are still two meetings left in the year, in September and November.

The aggressive stance from the SARB will prevent SA from falling behind the curve as other central banks turn more hawkish and help avoid a further ZAR blowout. However, what happens if SA slips into recession in the months ahead is still an open question, with further policy tightening holding the risk of political consequences in the coming months. Interest rate increases of July's magnitude are not a subtle instrument of paring inflation by tapping the economy's brakes. Furthermore, the economy is in bad shape following a decade of stagnation and as it buckles under the country's worst ever rolling blackouts.

But here lies the issue. The professional market has maintained out-sized interest rate hike expectations into next year. Though the past month has seen some of these interest rate expectations moderating slightly, they are back on the rise and are still overly hawkish. The market is looking through the current cycle at the potential economic slowdown and the implications this will hold for both inflation and monetary policy. For context, the Forward Rate Agreement (FRA) market is pricing in slightly more than 200bps worth of rate hike risk by the end of 2023. Notably, the 21x24 FRA is trading back above the 7.870% mark, increasing more than 40bps since the August lows.

The current expectations are driving the front-end of the FRA curve higher in anticipation of a hawkish outcome in the upcoming three-policy meetings. On the other hand, persistent inflation due to elevated oil prices and a depreciation of the Rand will keep long-term expectations elevated. Fixed income traders, for this reason, continue to pay FRAs. We have already seen the long end of the FRA curve invert, with the 21x24 rate trading below the 15x18 rate. In the swaps market, the 2v10 swap spread is trading just below 150bps, among some of its lowest levels on a year-to-date but still roughly 50bps higher than pre-covid levels.

Bottom line: The current tightening phase is set to lose steam in the final months of 2022. The in-house view is for a terminal interest rate of 6.50%, which may be reached in January 2023. As such, we presume SA is at the back end of its hiking cycle and see September’s rate hike lowered back to 50bps, potentially followed by a smaller and incremental 25bps hike in November and January next year before we begin to see the central taper in the later parts of the year. Going forward, new information, including economic data and policy remarks by the SARB, Rand weakness and oil prices, will determine the interest rate outlook. But these factors may very well be overlooked and influenced by what action the US Federal Reserve takes in the coming months. So far, SA’s rate hike campaign matches the Fed, and local policymakers will likely want to continue moving in tandem to prevent abrupt capital outflows and currency blow-off.