I am surprised at the amount of commentary and forecasts about how the world is moving away from the US dollar to other currencies. This in the face of a huge quantum of dollars in circulation and the balance sheet of the United States Federal Reserve (Fed) nearing $9 trillion – the largest number in the history of the central bank. The trade of global commodities and goods in dollars still far outpace any other currency at present. This means that the dollar is not going away soon and what the Fed says and does matters. But why?
The Fed is the custodian of dollars. It manages the dollar in two ways, firstly, through interest rates which change the price or cost of dollars to borrowers. Secondly, by supplying dollars to the globe through its repo, swap and quantitative balance sheet actions.
2022 was a textbook example of what it means when the Fed starts to matter. The world was quite sanguine about the Fed rate hiking cycle at the start of 2022. But when the Fed started to show hawkish intent by hiking more aggressively than market expectations, accompanied by hawkish statements, we witnessed how risk and duration assets came under severe price pressure leading to poor return outcomes for most asset classes in 2022. It has been quite amazing to see how the Fed and its next moves became the focus of news. Because when the Fed started to matter to global financial markets, everybody noticed.
So why do the Fed’s actions matter to South Africa?
When the Fed adjusts the price of dollars upward, it means the rand weakens and that brings the South African Reserve Bank (SARB) into play. The SARB does not explicitly target the rand, but it knows well that a weaker rand leads to higher inflation, which the SARB does target. The domestic market was surprised at how hawkish the SARB turned on inflation and rate hikes once the Fed did so. It seemed the SARB wanted to stay in lockstep with the Fed on rate hikes to maintain a real rate differential to United States (US) rates. Emerging markets like SA must maintain higher local interest rates to attract foreign capital to SA markets.
The good in all of this is that after more than a decade of very low interest rates globally, there is now value in interest rate markets again. Interest rates are currently more reflective of the true cost of capital. The risk of moral hazard or the creation of unsustainable companies due to low cost of capital is over for now. For investors looking to invest in safer asset classes, the various fixed income yield curves are now good opportunities to diversify away from risky asset classes as the risk of a possible recession increases. In the US and locally we are finding good real yield opportunities for clients at low risk.
Bond markets have been extremely volatile over the last year or more, but remember that volatility is not risk. The real risk in markets is overpaying for assets. At the moment, the US and SA fixed income markets looks attractively priced and there are good investment opportunities to lock in high real yields for the next year or more. Investors looking for a safe haven can invest in cash yield of close to 9%. We have not seen this in many years and currently cash is certainly king.
Pension fund investors looking for long-term real yield will find this opportunity in either the nominal or real yield curves. We remain of the view that SA nominal and inflation-linked bonds present attractive nominal and real return opportunity for investors over the medium to longer term.
The SARB will remain hawkish over the short term, but if there should be any economic fallout in the US the Fed will not hesitate to reduce interest rates again and may even increase the size of their balance sheet as well. This could mean the SARB once again follows the Fed to lower rates, which will benefit duration fixed income asset classes positively.
Watch this space: The Fed won’t matter until it matters too much and global central banks follow them toward lower interest rates once again.
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