A dramatic change in the
environment for the worst.
The problem is inflation.
If we go back a few weeks,
we had that horrendous Eurozone
inflation figure, inflation jumping
to 8.1% year on year.
Following that was the
US inflation print.
If we look at the chart, we had
expected that US inflation had
peaked at 8.5% back in March.
And indeed in April we saw a
slight decline of inflation
only for the May inflation
print to suddenly surge once
again - 8.6% inflation, while the
market was only expecting 8.1.
We have known for a while that
we've got a global inflation
problem, but what's become
apparent is this problem is far
larger than we had expected.
The result is that we are having
to price in significantly more
central bank hikes.
US, the US markets, are now
pricing that the Fed funds rate
is going to have to rise to 3.5%
at the end of the year.
And indeed the Fed followed
through with that with an
aggressive 75bp hike at their
meeting last week.
It was the first 75bp hike that
we've seen since 1994.
Admittedly, it could have
been worse.
Jerome Powell at least said 75bp
is not going to be the norm.
So this is a once off, probably
revert to 50bp hikes from here.
Nevertheless, the point is a
global inflation problem means
that central banks are going to
have to hike significantly more
than they would otherwise and
the risk of a policy mistake,
in other words the Fed, the ECB
driving their economies into
recession, grows.
In fact, we can even go further
than that and say that the only
way the global central banks
are going to bring inflation
under control is to engineer
a recession.
As a result, recession fears
have grown significantly.
A survey of US CEOs shows that
60% of them expect a US recession
in the next 12 to 18 months.
We've also seen similar sentiment
expressed in financial markets.
So if you look at US Treasuries,
we look at the ten year spread versus
the two year spread, that has now
moved negative.
Why that's such a big deal is
normally longer dated bond yields
are at a premium over shorter
dated yields.
The only time that changes,
is when the markets expect high
short term rates and then rates
falling over.
Why would rates fall over, turnover?
It's because the economy would
turn down.
So the fact that the 2V10 spread
has moved significantly into
negative territory is an indication
from the bond markets that they
are expecting a US recession.
And indeed the 2V10 has been a
very accurate predictor of US
recessions in the past.
Not to say that we're going to
have a recession right now.
Talk is middle of next year,
late next year.
But obviously the point is, we in
financial markets have got to price
in that risk.
The looming risk, the growing
risk of a US recession that would
impact the entire world.
We've seen that rippled through
global financial markets.
If you just look at the S&P500 Index,
it's been in a bear market territory
since the beginning of the year,
declining significantly.
And last week, indeed, we saw
the biggest single week decline
since when the pandemic broke
in 2020.
So the equity markets pricing
in a far less favourable economic
environment.
This of course reverberates
through into South Africa.
First channel is through
commodity prices.
If we look at our Terms of Trade Index,
the Terms of Trade Index is something
I focus on a lot, speak a lot about on
this channel, Terms of Trade is
South African export prices divided
by our import prices.
The point is when our export prices
are doing very well, visible in the
chart, that would imply a move to
the upper end of the chart.
When commodity prices are in
South Africa's favour, it would
be very good for local growth,
for the rand, etc.
Now as we see in the chart,
commodity prices, the Terms of
Trade have come off significantly
since the start of the year.
They are still at relatively high levels.
So this is not a panic territory yet,
it's still levels that are decent for
the rand, the balance of payments
in the economy, but obviously
far less favourable than the middle
of last year when iron ore was
doing so well, or particularly
early this year where the coal
price was doing so well.
So the commodity price
environment turning less
favourable for South Africa,
in my mind, is starting to
become worrying.
My take on the rand for the past,
for the entire year, in fact has
been that the rand should be
biased toward strength.
With this talk of recession,
commodity prices coming off,
starting to feel the bias is
switching the other way.
In other words, the bias now,
the risk now is towards
rand weakness.
Again, nothing to panic about
at this stage.
Commodity prices are still decent.
Furthermore, if you just think
about the relationship between
the Fed, what the Fed is doing
and the rand, while there is a
strong relationship between
the two.
But it is not Fed hikes that
historically have been negative
for the rand.
It's actually when the Fed cuts
for the first time.
And that may seem contradictory
at first.
Really what it's showing is that
when the Fed is hiking, that's
indicative of a strong growth
environment, rising inflationary
pressures, high commodity prices, etc.
However, when the Fed cuts,
it is a signal that the US economy
is rolling over and that all these
positives, high commodity prices,
a risk appetite for emerging markets
are going to evaporate.
So it's not panic stations yet.
I remind, when the Fed does
its first cut, historically, that's a
panic signal for the rand, that
signalling possible rand bout.
But for the moment, risk bias
is changing but not panic territory.
We are also seeing higher global
rates reverberate into our domestic
interest rate markets.
So bond yields have been
under pressure.
More to the point, rising pressure
on the Fed to hike aggressively
puts rising pressure on the
Reserve Bank to follow through
with its own aggressive hikes.
So remember the last SARB
meeting we saw a 50bp hike that
followed a 50bp from the Fed.
Now it is unlikely and truly
unnecessary that the Reserve
Bank will hike 75 in response
to the Fed 75.
Nevertheless, our economy
arguably does not need the same
type of hikes that the US has,
but the Reserve Bank may be
pressured to try and follow the
Fed to some extent to keep our
interest rate differentials solid and
to show that they have inflation
finding credibility, that they
are also prepared to hike rates
aggressively to combat inflation.
What you don't want in this
environment is to lose your credibility,
be seen as a central bank that is
not willing to take the tough medicine.
So pressure on our Reserve Bank mounts.
We've seen that reflected in the FRAs.
If you look at the green line,
the 12 by 15 FRA, the prediction of
where jibar is going to be in 12 months'
time, you can see at one stage last
week almost pricing 300bp of hikes
by the Reserve Bank over the next year.
Far more than we expect.
We only expect a 150bp taking
the repo rate to 6.25%.
But you can see just how that Fed
pressure is feeding through on to
the Reserve Bank.
Looking at the week ahead, policy
once again, very much in focus.
The global attention with the
highlight of the global calendar is
going to be Powell's address to Congress.
He does that twice.
He speaks, then the next day he
reiterates his comments.
So gives Congress an opportunity
to quiz him on what the Fed is going
to do about inflation.
So we are going to get a
lot of commentary.
How much does Powell think the
Fed has to hike, how quickly
they're going to hike, etc.
It's a lot of risk around that event.
On the local front, it's about inflation.
So we get our own May inflation print.
Expectations is that inflation
will jump to 6.1%.
So pretty much as we knew for
past few months, inflation breaching
the top end of the bend.
Nothing to panic about.
We've known this is coming.
However, the question is with
the Eurozone inflation print for May
substantially overshooting, the US
inflation print for May substantially
overshooting, could we see the same
in South Africa?
And then again that would put
significant pressure on our
domestic markets.
Overall, we are having a dramatic
change in the environment for
the worst.
Global inflation is a bigger
problem than we've expected.
That's changing the rand environment,
putting pressure on the Reserve Bank
to hike interest rates, putting
substantial pressure on equity markets.
But we're also in a period of extensive
financial market volatility.
Last three days of last week we
really saw huge swings in the rand.
That's probably going to continue
as we try, the markets try and figure
out exactly where we are and try and
find a new level to stabilise.
Good luck for the week ahead.