SARB delivers an unexpected cut

By Mokgatla Madisha, head of Fixed Interest at Sanlam Investments

The SA Reserve Bank (SARB) unexpectedly cut the repo rate by 100bps on Tuesday morning. No doubt the relative stability in the markets after the Moody’s downgrade gave the Monetary Policy Committee confidence to bring forward the May rate decision. Indeed, we had expected the SARB to announce a monthly meeting schedule at the last meeting, similar to what they did in 2008, at the height of the global financial crisis. While the timing of the cut was a surprise, that fact that they moved was not.

High after-inflation cash rates did not support growth

Over the past year we have repeatedly argued that real (after-inflation) cash rates of more than 2% were restrictive and not supportive of growth. However, we did acknowledge that the reason the SARB was erring on the side of caution by not cutting rates was because of the risks – escalating inflation being one of them – emanating from fiscal policy.

The rate cut prioritises economic growth

Recently our economists revised their inflation forecast to 3.7% for 2020 and 4.5% for 2021. So, based on our ‘fair value’ cash return, a repo rate of 4.8% was feasible. Tuesday’s repo rate cut to 4.25% is significantly lower than our fair value. As South Africa will surely remain in a recession in the coming months, monetary policy should not only be at fair value but stimulatory, and that’s exactly what the SARB is aiming for now.

How did the market react?

Tuesday was a risk-on day globally, as news over the weekend relating to COVID-19 had been encouraging. Death rates have started to slow in New York and Italy, Madrid allowed more workers to go back to work, and export data out of China was not as weak as forecast. Against this background the rand was trading about 12c firmer against the US dollar. Once the rate cut decision was announced the rand sold off 35c against the dollar. The decision came just before the weekly bond auction. There was a somewhat delayed reaction in the bond market but in the end the 3-year bond rallied about 71bps on the day, while the benchmark R186 (6-year bond) rallied only about 51bps and the R2048 bond, maturity 2028, rallied 25bps from its close on Thursday, 9 April. Bond yields had been trading about 10bps up prior to the announcement.

Where to from here for interest rates?

Given the scale of the output contraction expected this year we think the repo rate could eventually be cut to 3%. Inflation and rand trajectory will be key in determining whether the SARB will cut enough to reach that level. At this stage we can say that returns from cash will not be appealing over the next 12 months.

All eyes are now on government’s fiscal policy

For bonds longer than three years, fiscal policy is much more important than interest rate decisions. In February, National Treasury was forecasting a deficit of 6.8% for 2020/21. As a result of the 21-day lockdown we were of the view that the deficit will reach 10% of GDP, which would result in a funding requirement of close to R590 billion compared to R407 billion in the 2019/20 fiscal year. Standard Bank projects that the extra two weeks of lockdown and resulting economic contraction could push the funding requirement to R740 billion.  We do not share the SARB or National Treasury’s view that such large deficits can easily be financed in the domestic market. South Africa’s yield curve is one of the steepest amongst emerging markets and Tuesday’s action by the SARB and government’s fiscal policy will ensure that the curve stays steep. We are overweight in the 10- to 12-year sector of the curve and we will maintain this position. Funding at real rates far higher than the economic growth rate will lead to a debt/GDP ratio that does not stabilise.