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5 factors to keep in mind

by Sean Tweedie | May 31, 2021

This month has seen risk assets continue to outperform as a consequence of a notable improvement in investor optimism following several contributing factors. The successful rollout of vaccines in many parts of the world (particularly in the developed economies), an improvement in economic activity following the easing of lockdown restrictions, easy monetary policy and very generous fiscal policy are just a few noteworthy factors underpinning the increase in investor appetite. The rand has certainly benefited in this environment and has recently reached lows versus the dollar last seen in 2019. The combination of a firmer rand together with a broadly weaker dollar provides welcome relief and an opportunity for importers on the one hand but hurts exporters on the other.

In this edition we reflect on five factors which we believe will be the biggest currency drivers over the coming months.

Factor 1: Growth momentum is rotating from the U.S to the rest of the world

This theme has been playing out since the peak of the DXY index (U.S dollar index is used to measure the value of the dollar against a basket of currencies) in March this year. Huge amounts of fiscal stimulus and an aggressive vaccine rollout saw U.S growth recover faster than the rest of the world. However, this trend is now reversing with the rest of the world catching up as vaccine rollouts pick up pace and economies open. We are already witnessing this phenomenon in the data releases. Presently manufacturing PMIs around the world have overtaken U.S levels, and it is only a matter of time before the services PMIs catchup to that of the U.S. Figure 1 shows how this is playing out in the euro area.

If this trend continues it will be negative for the dollar.

Figure 1

Factor 2: Rising inflation and the chance of an overshoot

There has been a significant emphasis on inflation dynamics lately. For good reason. Exchange rates tend to reflect real interest rate differentials, since inflation erodes the purchasing power of a currency. As such, it is important to gauge not only what is happening to nominal rates, but also to underlying inflation trends. Currency markets however, specifically the dollar, have been paying close attention to the inflation differential between the U.S and other countries, and what that means for relative real rates. A rising inflation differential between the US and its trading partners has been negative for the dollar. Recently we have seen U.S inflation overshooting the target threshold. Investors are still gauging whether this overshoot if merely transitory or whether it reflects a more permanent increase. Nevertheless, upside surprises in inflation are likely as the U.S output gap (difference between an economy’s actual output and its maximum potential output) closes faster than other countries.

Factor 3: The Federal Reserve remaining ultra-accommodative

Higher inflation can allow for the Federal Reserve to raise interest rates. Certainly, if higher inflation proves permanent the Federal Reserve’s hand may be forced. However, as we stand there is little evidence that this is the case yet. The Federal Reserve has also on numerous times reiterated their dovish stance on monetary policy and that an inflation overshoot would not necessarily warrant any change to their stance. The Federal Reserve is in fact the only member of the G10 which is committed to an inflation overshoot. If this is the case, then we may well see real interest rates in the U.S continue to erode and put further downward pressure on the dollar. See Figure 2.

Figure 2

Factor 4: The dollar is expensive and the rand still cheap

According to BCA’s long-term fair value model, the dollar is overvalued by about 7%. See figure 3.

Figure 3

This suggests that on a Purchasing Power Parity basis, the dollar can still trade lower towards its fair value. Contrastingly, BCA’s long-term fair value model shows the rand is slightly undervalued and which then suggests the rand has scope to strengthen further and even trade at a premium to its fair value. The fair value of the rand is also picking up following a structural decline over the past decade. See Figure 4.

Figure 4

Factor 5: U.S inflows are waning

TIC (Treasury International Capital) data is useful when looking at currency valuations as it holds valuable insights into foreign appetite for U.S assets. In the past the U.S witnessed strong inflows into the equity markets, which helped support the dollar. With the dollar down since March, it is a fair assumption that the strong inflows we saw since then have somewhat reversed. Foreign inflows into the US equity market tend to be driven by expected rates of return and with growth rotating from the U.S to the rest of the world, foreign appetite for U.S equities will be curtailed.

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