A Dovish Surprise Play

Prior to the recent aggressive sell-off in risk assets, the performance of the Rand had been rather puzzling. The currency maintained relative strength even as the dollar gained momentum against other currencies. Two things seem to have been keeping the rand afloat – positive real interest rates and favourable Terms of Trade given the rise in commodity prices. This appeared to be enough for investors to turn a blind eye to the country’s weak economic fundamentals. While real rates remain supportive, other negative factors have emerged and taken a dominant weighting on risk sentiment. The broad commodities run has largely turned for now and the concern around Evergrande in China seems to be deepening.

It’s anyone’s guess how the Chinese authorities will respond to this crisis. While minimal intervention and support would fall in-line with the government’s de-leveraging drive, the potential contagion does pose a significant risk to local economic growth. Regardless of how this saga is resolved, it seems clear that the longer-term impact on the Chinese property & construction sector doesn’t look good. It’s important to note that China served as the engine for global growth after the financial crisis – and their over-investment in property and construction projects was a huge source of this global demand. These latest developments will likely have some implications on the commodity cycle and ultimately on South Africa’s Terms of Trade.

Fed week typically brings with it potential currency volatility on the back of announcements coming from the meeting. However, given the fact that the market was expecting little surprise from the Fed, it appears the stress emanating from China will have a much higher weighting on global risk sentiment this week. That being said, we think it’s possible that these developments will give the doves in the Fed leadership some ammunition. While current US economic conditions may make it difficult for the Fed to sound more dovish than they were at Jackson Hole, global growth conditions do matter.

The market will probably be sensitive to any movement in the median dot-plot signaling the potential first rate hike. In the event the Fed does surprise on the dovish side, there is potential for the dollar to weaken, giving risk assets a bit of a relief rally. Looking at the daily USD/ZAR chart below, this scenario sets up a potential short opportunity below the 50% Fibonacci level where a hanging man candle seems to be forming.

If this scenario were to play out, it could also provide better entry opportunities for one looking to play the weaker long-term ZAR theme based on fundamentals.

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