South Africa is back in a rate cut season

The SARB decided to lower the repo rate by 25bps last week. Readers will recall that in November 2016 I predicted a recession and the commencement of the rate cut cycle in 2017 (in fact I said we were already in a recession back in November). This analysis is reproduced in this blog post.

Herewith a reminder of the three key concluding paragraphs of this analysis:

In my view, the economy is heading into recession in 2017. It’s not a consensus view at this point as a Bloomberg poll of 24 economists sees growth at 1.1% in 2017 and 1.8% in 2018. National Treasury itself pencils growth of 1.3% in 2017, another optimistic growth forecast that’s likely to be missed (again). NT has been perma-bullish on growth in the past six years (see graph below; deleted for this blog post). This means the economy would be going into a recession in a historically wide fiscal deficit position, while recessions typically see the fiscal surplus/deficit drop by around 4 percentage points.

After pricing a steep rate hike cycle at end-2015 (nearly 200bps of hikes were priced in before end-2016), the market is priced for a 50% chance of another 50bps rate hike before end-2017. There are obviously clear ZAR risks introduced by the politics that could drive a final flurry of hikes from SARB. With the economy going into recession, a weaker USD that leads to ZAR strength, and a weak retail environment that contains price inflation, the SARB is likely to turn less hawkish. Moreover, we continue to expect that the central bank theme of 2017 will be one of policy CONvergence where the Fed joins the loosening party again. This feeds into our bearish tactical USD view that feeds into a lower USD-ZAR and lower SA inflation expectations. If this cocktail is served to the SARB governor, Mr Kganyago, we reckon it’s likely to eventually lead to the commencement of a rate cutting cycle.

The last time I predicted a major directional trend shift call to policy rates was in mid-2013 by calling an end of the cutting cycle and spoke about the clear risks that a short-term rate hiking cycle would commence (consensus disagreed—see this interview—back in the days when USD-ZAR was steady at 9, and the policy rate 200bps lower than today). The call was 6 months early but bonds reacted to this view early. With respect to my panellists in that interview I believe what they were missing at the time was to correctly account for the global macro dynamics that would drive the hiking cycle that I elaborate on in Part 2 of the interview. Right now, as I’ve argued consistently in recent months, I foresee global macro relief coming from a more dovish Fed and weaker USD, and recovery in emerging markets (eg. look at the pick-up of leading indicators across the board in Brazil, Russia, Turkey and China at the moment). Coupled with flat inflation in SA and an economy going into recession, the 10yr bond yield could drop from 8.9% currently to 7.5% before turning back into its long-term uptrend. I wouldn’t chase this short-term rally, though, as it is likely to be short-lived once governments of developed economies (and SA) abandon austerity policies and embrace helicopter money in earnest (curve steepeners and higher inflation expectations). Other EM’s not following developmental state ideologies that allow their private sectors to drive growth are likely outperform SA on the growth front (eg. Brazil and India).

In the last four rate cut cycles (late 1980s / mid-late 1990s / early 2000s / late 2000s) the SARB reduced the repo rate on average by 6.75 percentage points. Starting off at 7% in 2017, people might be shocked at how low rates end up going through this cycle, with the one caveat being that the SARB hiked the repo rate less than prior hiking cycles (1.25pp in last two years vs average of 5.1pp before) which means the cutting cycle might be shallower than usual.

As I’ve been arguing for nearly a year now, we’re in rate cut season. It’s a mug’s game trying to predict SARB moves on MPC day. They often don’t know themselves what they should or should not be doing. More important is that one calls the big swings of interest rates–early, even before the SARB and the market knows it’s about to happen–and ride that trend. In the next two years I’ll keep betting on rate cuts, unless a major external economic or internal political shock derails the trend.