On Thursday, 21 May the South African Reserve Bank cut the repo rate by 50 basis points – in line with general market expectations as well as our own expectation. This brings the repo rate to its lowest point on record.
Source: IRESS
Drastic monetary policy measures in line with rest of the world
The Reserve Bank’s decision to cut interest rates and to implement measures to increase liquidity in the market is not unique to South Africa. Other leading central banks around the world have implemented aggressive measures to minimize the adverse effects of COVID-19 on their respective economies. For example, already in March the US Federal Reserve Bank slashed the federal funds rate to near zero and expanded its balance sheet by purchasing a range of assets.
As South Africa continues to contend with the effects of COVID-19, various interventions will be required in order to support the country’s already fragile economy. The governor of the Reserve Bank, Lesetja Kganyago, further cautioned that monetary policy on its own is not sufficient and that other prudent macroeconomic policies and structural reforms would be required in order to cushion and revive the South African economy. Moreover, the country’s GDP forecast has been revised downwards and CPI lower, and risks are still assessed to be downside. The Reserve Bank revised its GDP forecast to a deeper contraction at -7.0% for 2020, compared to the previously forecast -6.1%.
At the beginning of May 2020, the SA government partially relaxed the five weeks of hard lockdown and permitted some businesses to operate in addition to essential services. However, the South African economy may take longer to recover because phase 4 of the lockdown still excludes many activities. As a result, reduced business activity and low inflation rates pave the way for further rate cuts in the future.
On the day of the Reserve Bank’s decision to cut the repo rate to 3.75% the rand strengthened against the US dollar, a positive reaction perhaps but it’s also noteworthy to remember that the rand was particularly weak and potentially quite oversold.
Effect on fixed interest portfolios
From a portfolio point of view, we had already seen the local interest rate market rally significantly (i.e. trade stronger) in anticipation of the interest rate cut. This – and material market strength so far during the second quarter – benefitted fixed interest funds’ performance in the short term. However, there is a downside to all the rate cuts: the inverse relationships between the yield and price of a fixed interest instrument. When interest rates decrease, the price of the instrument increases, which leads to an increase in value or a shorter-term profit. But, in fact, it decreases the forward-looking return prospects or yield of the instrument.
It’s the inflation-adjusted returns that really matter
It’s important to remember that we are in a very soft inflation environment. At least clients can take comfort in the fact that the historic and current inflation-adjusted returns are still looking good and are in positive territory. Interestingly, our positive yield environment locally is in contrast to the global environment where we have seen negative yields become more prevalent. This has been causing a problem for not only savers but also for the global economy with many unintended consequences and unanswered questions about the wider implications of negative rates. The lower yields currently available locally at the ‘shorter end of the curve’, i.e. the repo rate, now make fixed interest products even more important.
