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NOMURA emerging markets expert Peter Attard Montalto explains why he sees the interest rate
unchanged at 5.00% again after the monetary policy committee's (MPC's) meeting on Thursday:
The size of risks is increasing to the dovish side on growth and to the hawkish side on inflation. However, they continue to balance out, which suggests rates should remain stuck at this week’s meeting.
Don’t the weak local data and slower growth in China mean the MPC wants to cut?
We believe the MPC is very focused on the China growth issue as the key new marginal negative external growth risk for South Africa. China has become the number one export market for a number of commodities, and has been instrumental in South Africa’s robust export growth over the past year.
China’s slowdown and the possibility that growth there may be as low as 7% this year is a key drag on South Africa, but not a big or sharp enough shock to push the MPC into action in our view.
The downside risks of a hard landing from a disorderly rebalancing of the Chinese banking sector and in particular the shadow banking institutions are still distant possibilities, dismissed for now by the notion the state may be able to use some creative accounting and parcel risks and defaults around the system.
Until that scenario becomes a much higher or even baseline probability, we do not expect a rate cut.
But the last consumer price index (CPI) print at 5.6% for May was supportive, right?
South African Reserve Bank (Sarb) governor Gill Marcus did indeed say she was pleased with that print, but the comment was also qualified with concern looking forward. The key is the balance between growth and inflation. Just as the negative factors stack up on the growth side, so the inflation upside risks mount too.
In particular, we understand the MPC considers alternative scenarios that incorporate its tail risk concerns of inflation moving markedly higher under a switch to import pricing by retailers and along their supply chain (though there is only very marginal evidence that this is happening at all yet), as well as currency pass-through effects building because the rand has remained stuck at its present level.
Hence, while the Sarb’s CPI forecast may take a small step lower in the short term from the last print, over the medium term we think it will probably remain unchanged in the baseline and skewed more to the upside in the risk profile due to these factors.
Hence, we think the MPC will be just as worried about inflation risks as at the last MPC meeting.
But couldn’t the MPC at least appear dovish, suggesting it would like to cut, like last time?
Last time the market overreacted to the idea that one member of the MPC was interested in (though did not push for) a rate cut. There was a slight shift in tone in the statement last time from the more hawkish end of neutral to the slightly more dovish side, but we think that was very marginal.
We have to remember the balance of growth and inflation remains in check, suggesting no change. Indeed, for a risk-averse, conservative MPC, we think the hurdles to moving rates at this point are simply too high.
We think the MPC would need to see a much larger external growth shock to cut rates this year (one that overrode any increased inflation risks from a weaker currency in such an environment), while to hike rates it would need to see a meaningful and evidence-based shift in retailer pricing mechanisms or the currency much weaker from here as to shift to the inflation forecast over a decent amount of time.
The market may well overreact again, especially if another member is said to back a cut. However, we still think that the MPC framework will remain constant and the market needs a more sober interpretation.
Growth forecasts may well be revised down a little further, though we think the MPC has already been more bearish than the Sarb staff forecast so that should be largely irrelevant.
Where is the MPC on the taper timeline/debate?
We believe the MPC fully expects tapering (the scaling down of the US Federal Reserve's bond-buying programme, known as quantitative easing) to occur though the fourth quarter, but whether it starts in September or December is probably of only marginal importance.
The key is that the market is shifting to focus on domestic idiosyncrasies, and here the MPC knows that South Africa is found wanting.
We also think the MPC understands it will need to normalise real policy rates at some point in this taper environment, though the current low growth and the counteracting balance of inflation risks leaves it unable to do that at the moment and so it’s likely a topic for next year.
Given the market concerns over sovereign risk and the current difficult wage round, we fully expect the MPC to continue to sound a strongly cautious note on structural issues and the role of government rather than the Sarb to address these. The overall tone of the MPC should therefore be pretty similar, in our view.
We also think the Sarb will reiterate its commitment to stand back from the currency (privately happy with risk premia shocks feeding through to government), though we will be interested to see the exact wording on the currency as it has been volatile, yet in a pretty stable range around 10 since the end of May.
However, the increasing debate locally on the benefits of a weaker currency may well be nipped in the bud at the press conference. The Sarb has benefited in market credibility terms so far from its hands-off approach and will likely want to main this as the Fed tapering approaches.
What about European Central Bank/Bank of England forward guidance, anything like that from the Sarb?
There seems to be a communications problem for the Sarb – though this is more the market’s fault than that of the MPC. The volatility of market pricing of future rates has been considerable this year.
However, we think the Sarb has been pretty consistent in laying out its view, and it is more the scepticism of markets and in particular fast money and some locals that have driven a view that rates will go somewhere that the MPC has quite clearly signalled it does not think is likely.
Indeed, there has already been a lot of public (and behind the scenes – as we laid out in our trip notes: Joburg and Pretoria in a post-Fed QE world) framework detailing by the MPC, which we think clearly lays out how the MPC would react under different scenarios and how this can be collapsed down into a sensible baseline.
Reading between the lines, this looks like a (very) soft form of recommitment if you ignore the headline statement from the MPC that it will move rates in any direction needed to meet its mandate.
So there won’t be a surprise cut like last year?
The MPC surprised strongly at the July meeting last year by cutting rates by 50 basis points. However, some analysts had forecast the cut and the market was pricing the move.
But given the Sarb’s wish not to be seen to move the currency in either direction, and markets now pricing fully a hike in the coming year with no chance of a cut at all in the near term, we think the present situation is very different from last year.
Arguably, last year (with hindsight) there was a weakening shift going on beneath the surface in gross domestic product while external growth shocks mounted and CPI was surprising the MPC to the downside, i e the “see-saw” of risks of was out of balance and skewed towards a cut (we argued at the time it wouldn’t cut as the upside from doing so was too limited).
However, the see-saw now seems to be far too firmly in balance for a repeat of this situation, and the MPC has stated firmly and publicly that it does not want to be seen to be doing the heavy lifting work of boosting the economy when it is the government’s job to make structural reforms.
We also believe there is significant scepticism on the MPC at the moment about the point or benefit of cutting rates here anyway, even ignoring the currency and inflation issues.
Finally, remind us of your baseline for rates.
We see rates unchanged at this week’s meeting and then through the rest of the year as the growth and inflation risks continue to cancel each other out.
However, into Q2 next year we see the underlying core inflation rate starting to trend higher given the passthrough effects of foreign exchange, large wage increases in real terms in this wage round and some pricing shifts by retailers, as well as from the output gap starting to close after the trough in growth in the middle of 2013.
Hence, we see that as the key trigger for the MPC to start to normalise real policy rates to positive territory from the May meeting next year. If growth is a lot weaker then we think that could fall back slightly, and (less likely) vice versa.
unchanged at 5.00% again after the monetary policy committee's (MPC's) meeting on Thursday:
The size of risks is increasing to the dovish side on growth and to the hawkish side on inflation. However, they continue to balance out, which suggests rates should remain stuck at this week’s meeting.
Don’t the weak local data and slower growth in China mean the MPC wants to cut?
We believe the MPC is very focused on the China growth issue as the key new marginal negative external growth risk for South Africa. China has become the number one export market for a number of commodities, and has been instrumental in South Africa’s robust export growth over the past year.
China’s slowdown and the possibility that growth there may be as low as 7% this year is a key drag on South Africa, but not a big or sharp enough shock to push the MPC into action in our view.
The downside risks of a hard landing from a disorderly rebalancing of the Chinese banking sector and in particular the shadow banking institutions are still distant possibilities, dismissed for now by the notion the state may be able to use some creative accounting and parcel risks and defaults around the system.
Until that scenario becomes a much higher or even baseline probability, we do not expect a rate cut.
But the last consumer price index (CPI) print at 5.6% for May was supportive, right?
South African Reserve Bank (Sarb) governor Gill Marcus did indeed say she was pleased with that print, but the comment was also qualified with concern looking forward. The key is the balance between growth and inflation. Just as the negative factors stack up on the growth side, so the inflation upside risks mount too.
In particular, we understand the MPC considers alternative scenarios that incorporate its tail risk concerns of inflation moving markedly higher under a switch to import pricing by retailers and along their supply chain (though there is only very marginal evidence that this is happening at all yet), as well as currency pass-through effects building because the rand has remained stuck at its present level.
Hence, while the Sarb’s CPI forecast may take a small step lower in the short term from the last print, over the medium term we think it will probably remain unchanged in the baseline and skewed more to the upside in the risk profile due to these factors.
Hence, we think the MPC will be just as worried about inflation risks as at the last MPC meeting.
But couldn’t the MPC at least appear dovish, suggesting it would like to cut, like last time?
Last time the market overreacted to the idea that one member of the MPC was interested in (though did not push for) a rate cut. There was a slight shift in tone in the statement last time from the more hawkish end of neutral to the slightly more dovish side, but we think that was very marginal.
We have to remember the balance of growth and inflation remains in check, suggesting no change. Indeed, for a risk-averse, conservative MPC, we think the hurdles to moving rates at this point are simply too high.
We think the MPC would need to see a much larger external growth shock to cut rates this year (one that overrode any increased inflation risks from a weaker currency in such an environment), while to hike rates it would need to see a meaningful and evidence-based shift in retailer pricing mechanisms or the currency much weaker from here as to shift to the inflation forecast over a decent amount of time.
The market may well overreact again, especially if another member is said to back a cut. However, we still think that the MPC framework will remain constant and the market needs a more sober interpretation.
Growth forecasts may well be revised down a little further, though we think the MPC has already been more bearish than the Sarb staff forecast so that should be largely irrelevant.
Where is the MPC on the taper timeline/debate?
We believe the MPC fully expects tapering (the scaling down of the US Federal Reserve's bond-buying programme, known as quantitative easing) to occur though the fourth quarter, but whether it starts in September or December is probably of only marginal importance.
The key is that the market is shifting to focus on domestic idiosyncrasies, and here the MPC knows that South Africa is found wanting.
We also think the MPC understands it will need to normalise real policy rates at some point in this taper environment, though the current low growth and the counteracting balance of inflation risks leaves it unable to do that at the moment and so it’s likely a topic for next year.
Given the market concerns over sovereign risk and the current difficult wage round, we fully expect the MPC to continue to sound a strongly cautious note on structural issues and the role of government rather than the Sarb to address these. The overall tone of the MPC should therefore be pretty similar, in our view.
We also think the Sarb will reiterate its commitment to stand back from the currency (privately happy with risk premia shocks feeding through to government), though we will be interested to see the exact wording on the currency as it has been volatile, yet in a pretty stable range around 10 since the end of May.
However, the increasing debate locally on the benefits of a weaker currency may well be nipped in the bud at the press conference. The Sarb has benefited in market credibility terms so far from its hands-off approach and will likely want to main this as the Fed tapering approaches.
What about European Central Bank/Bank of England forward guidance, anything like that from the Sarb?
There seems to be a communications problem for the Sarb – though this is more the market’s fault than that of the MPC. The volatility of market pricing of future rates has been considerable this year.
However, we think the Sarb has been pretty consistent in laying out its view, and it is more the scepticism of markets and in particular fast money and some locals that have driven a view that rates will go somewhere that the MPC has quite clearly signalled it does not think is likely.
Indeed, there has already been a lot of public (and behind the scenes – as we laid out in our trip notes: Joburg and Pretoria in a post-Fed QE world) framework detailing by the MPC, which we think clearly lays out how the MPC would react under different scenarios and how this can be collapsed down into a sensible baseline.
Reading between the lines, this looks like a (very) soft form of recommitment if you ignore the headline statement from the MPC that it will move rates in any direction needed to meet its mandate.
So there won’t be a surprise cut like last year?
The MPC surprised strongly at the July meeting last year by cutting rates by 50 basis points. However, some analysts had forecast the cut and the market was pricing the move.
But given the Sarb’s wish not to be seen to move the currency in either direction, and markets now pricing fully a hike in the coming year with no chance of a cut at all in the near term, we think the present situation is very different from last year.
Arguably, last year (with hindsight) there was a weakening shift going on beneath the surface in gross domestic product while external growth shocks mounted and CPI was surprising the MPC to the downside, i e the “see-saw” of risks of was out of balance and skewed towards a cut (we argued at the time it wouldn’t cut as the upside from doing so was too limited).
However, the see-saw now seems to be far too firmly in balance for a repeat of this situation, and the MPC has stated firmly and publicly that it does not want to be seen to be doing the heavy lifting work of boosting the economy when it is the government’s job to make structural reforms.
We also believe there is significant scepticism on the MPC at the moment about the point or benefit of cutting rates here anyway, even ignoring the currency and inflation issues.
Finally, remind us of your baseline for rates.
We see rates unchanged at this week’s meeting and then through the rest of the year as the growth and inflation risks continue to cancel each other out.
However, into Q2 next year we see the underlying core inflation rate starting to trend higher given the passthrough effects of foreign exchange, large wage increases in real terms in this wage round and some pricing shifts by retailers, as well as from the output gap starting to close after the trough in growth in the middle of 2013.
Hence, we see that as the key trigger for the MPC to start to normalise real policy rates to positive territory from the May meeting next year. If growth is a lot weaker then we think that could fall back slightly, and (less likely) vice versa.
