QE2 and its implications for the Rand

As we have mentioned before, we expect the Rand to strengthen against G7 currencies toward the end of this year. Along with this, we still expect the CPI inflation rate will surprise on the downside toward the middle and end of 2010 as base effects kick in and as FIFA 2010 and Eskom tariff increases have a deflationary effect on the CPI. The continued weak M3 money creation (+0.6% y/y in Jan vs +1.6% y/y in Dec) and the contraction in private sector credit extension (-1.1% y/y in Jan vs -0.8% y/y in Dec) will also be CPI deflationary. The CPI which tracks toward the lower end of the target band (3%) plus still weak job growth and stress in consumer spending owing to high private debt levels, may pressure the SARB into lowering the repo rate further, perhaps by another 100 to 200 bps.

A major structural issue that will further support the Rand – and something we have expected for some time now – is the resumption of QE by G7 central banks in Q2 but possibly Q3 2010 – the most likely candidates being the Bank of England, the Federal Reserve and the European Central Bank (more or less in that order).

The two electrodes used by our central planners to defibrillate the economy’s pulseless heart in 2008/09 were 1) quantitative easing via the Fed and 2) fiscal stimulus via the Treasury. We’ve received a massive dose of QE to this point, and we’ve had just as big an amount of fiscal stimulus. The risk was run that these electrodes would do nothing but burn holes in the economy’s chest cavity, ie that it wouldn’t bring about an economic recovery which would feed through to increased tax revenues which governments could use to reduce deficits and repay debt.  This will lead to even bigger complications down the road because the move to full debt monetisation is outright money printing Zimbabwe style and heightens inflation risk substantially.

Take the example of the Brits: they saw net borrowing equal to some £5 billion in the month of January 2010 alone – and January is historically a surplus month. The reason was a much larger than expected drop in tax revenues – implying no economic recovery – and meaning more borrowing by the government to fund its spending. What is likely to happen there is that, while tax revenues fail to rebound strongly in 2010 according to expectations, QE will have to be resumed. But there will be a subtle yet material difference between this time and last time round: the quantitative easing will be focussed primarily on buying government debt in the form of gilts and treasuries – and less so on buying toxic financial assets. Quantitative easing then becomes Debt Monetisation. But QE2 has a better ring to it. QE2 will be a way of financing the government in the hope that some sort of economic recovery will see to a stop in money printing sometime in the future.

Take the example of the US: Mish Shedlock writes that the state of California is now demanding income tax payments in advance of actually earning that salary. The state of California cancelled a $2 billion bond offering this week which would have helped ease its fiscal crisis. The Peach County in Georgia is looking at cutting the school week to four days to reduce the size of their budget. Go see some of the other problems with state, city and town budgets at Mish’s blog. Now bear these regional problems in mind when you look at the following revenue projections laid out by the US Treasury for its budget 2011. Find the official PDF file here.

The US Treasury expects revenue growth of 18% in 2011 from 2010, and a further growth of 14% in 2012 from 2011. This is way higher than their GDP growth forecasts of 4.6% in 2011 and 5.9% in 2012. These additional receipts will need to be borrowed in the domestic market, from overseas or come from increased taxes. It is unlikely that it will come from increased taxes or private investors – if it were to come from here, investors would demand a premium over current government debt yields in order to make up for the shortfall of savings and increased debt issuance. We foresee these shortfalls will be filled by the Fed in the form of credits in the banking system in exchange for Treasuries. Alas, the Treasury seems to agree. They foresee “borrowing and other net financing” making up nearly half of policy revenues in 2011.

As a result of these poilcies, we expect the Rand will appreciate strongly against the GBP, USD, EUR, and JPY once QE (debt monetisation) is resumed (begins in earnest). We expect this move lower could take place as soon as Q2 or Q3 2010. If uncertainty surrounding QE2 rears its head in March 2010, we expect there will be a sell-off in so-called ‘risk’ assets which would drag the Rand lower in the short-term, but this would only further increase the probability for QE2. Either way, we expect the Rand will hold its ground against the likes of the GBP despite weakness against the USD. Toward the end of 2010 the trend for the Rand remains stronger against these majors. While our target for an average USD/ZAR of 6.40 in 2010 might look a bit far-fetched at the present time, wait until you see the market’s reaction to the realisation that QE2 will be supporting government spending, not asset markets. We think it will be significant and lead to a significant re-pricing of EM currencies.