The rand’s implied volatility against the dollar tells you one thing about the currency in 2019: it’s going to be a wild ride. It’s just not clear which way.
The cost of hedging in the options market against price swings in the local currency over the next year has climbed almost 500 basis points since April. Though it has moderated from its September high, it’s still about 200 basis points above the five-year average.
The rand has been buffeted by trade tensions between the US and China, South Africa’s biggest trading partner. The way that dispute pans out remains a risk in 2019, along with the Federal Reserve’s policy path, the trajectory of global growth and commodity prices.
Meanwhile, the country is one step away from a trifecta of junk credit ratings, and a national election in May will add to local risks.
The uncertainty is reflected in analysts’ forecasts for the rand: though the median is for the currency to appreciate more than 2% to R13.95/$ by end-2019, the range of predictions is wide. The most bullish, Nomura International, sees the rand ending the year at R12.75/$, the most bearish, JPMorgan Chase & Co expects it to hit 16.50.
The bear case
JPMorgan expects South Africa’s economic growth to remain anemic against a global backdrop of rising rates and a stronger dollar. That could lead to fiscal challenges and a credit-rating downgrade by Moody’s, which would see the country’s local-currency bonds exit indexes of investment-rated debt, triggering forced selling of as much as $7bn, according to Citigroup.
"South Africa enters 2019 with large vulnerabilities," JPMorgan analysts Saad Siddiqui, Anezka Christovova, Milo Gunasinghe and Jonny Goulden said in a report. "Its ability to run a wide current-account deficit will be tested in an environment of tighter external funding conditions. Low carry compensation for fundamental weaknesses underscores our structurally bearish view on the rand."
As the rand weakens and inflation accelerates, the South African Reserve Bank may be forced to raise its policy rate by as much as 75 basis points to 7.50%, further retarding any economic recovery, they said. Investors will also be wary of populist policy moves by the ANC as the election approaches, with "headline noise" increasing rand volatility.
The bull case
A constructive view on the rand is supported by an orthodox central bank, strong and convincing disinflation, ongoing improvements in South Africa’s external balances, government measures to curb corruption and an overhaul of indebted state-owned companies, said Henrik Gullberg, a London-based strategist at Nomura.
As the US economy slows and inflation expectations moderate, the Fed would be inclined to soften its policy stance, Gullberg said. As South Africa depends on portfolio flows to finance its current-account deficit, that would benefit the rand.
"Needless to say, the US inflation and policy outlook remains key for the rand, given its high external beta," he said.