Monetary Policy Madness

The Impact of Rising Rates on the ZAR

In this post I will explore the relationship between interest rates and the value of the rand. Interest rates are one of the tools in the South African Reserve Banks arsenal to enact monetary policy across the nation. For a quick refresher monetary policy are the actions of the reserve bank to help the country achieve their macroeconomic goals such as controlling inflation as well as promoting economic growth.

The realm of finance theory an interest rate hike will usually trigger a spur of activity in the foreign currency markets. The general principle is that when a country hikes interest rates it will attract foreign investors seeking a higher return on capital. For example, if the South African Reserve Bank hikes interest rates finance theory suggest that foreign investors will sell their foreign currency, such as US dollars, and purchase ZAR in search of higher yields on fixed income instruments such as bonds. As a result, in the increase in demand for Rand should drive its value higher and strengthen the currency. Remember when the rand strengthens to the dollar the price you pay for each dollar in rand terms decreases. So, the rand moving from R19 to R18 is an appreciation / strengthening of the rand and vice versa. The theory sounds simple right? Well, not so fast.

Sometimes we all need a reality check and modern finance theory is no exception. Any seasoned economist or observer of the currency markets will know that the finance world has the knack for throwing curve balls every now and then. The relationship between interest rates and currency values are no exception. While the finance theory discussed seems to paint a clear picture of the relationship between interest rates and the ZAR, in reality the value of the rand is determined by numerous factors.

Lets explore some of these briefly:

1. Market Sentiment: Currency markets can be driven by emotion and sentiment of traders and investors making them as fickle as a teenage crush. A change in sentiment can overshadow the impact of interest rate hikes.

1. Macroeconomic Indicators: Interest rates are just one piece of the puzzle. Other macroeconomic indicators such as GDP growth, inflation and political stability play an important role in determining a currencys value. Rising interest rates can have negative implication or forecasted GDP growth which in turn would have a negative impact on the value of the ZAR.

1. Market Expectations: Financial markets have a habit of already pricing in events that are expected to place well in advance. If the financial market has already priced in an expected interest rate hike, then actual impact of the interest rate hike may be subdued. On the other hand, if investors expectations differ from reality this may cause further volatility in the currency market. For example, assume investors expect SARB to hike interest rates by 50 basis points (fancy way of saying 0.5%) but instead rates are hiked by only 25 basis points, this difference between expectation and reality would not be priced in by the market and will lead to short term volatility.

So, as we wrap up it is important to remember that finance theory is merely a guide and is not a crystal ball predicting the future. While the theory suggests that a hike in interest rates should strengthen the rand the reality is opaque. A clear example of this is the recent interest hike by SARB which led to a devaluation of the rand. This was as a result of the concern of the impact this will have on the economy and GDP growth far overshadowing the anticipated increase in demand for the ZAR from foreign investors. It is thus important to not view one event in isolation but rather keep an eye on the bigger picture.