Historically speaking, when it comes to interest rates, we are at historically low levels among developed economies. The rates are so low but recently the ECB surprised the market by initiating negative rates in a desperate attempt to force spending and thus spoking inflation. The hope is that negative interest rates will reduce the incentive to save instead stimulate consumer spending.
In this environment, it makes sense for investors who are chasing yield, to park their money in the countries which are moving away from this easing cycle and are already starting to raise the main interest rates. One such country doing this is South Africa; with the South African Reserve Bank (SARB) setting the policy. The reason why the South African Rand (ZAR), an exotic currency, is the perfect candidate for the carry trade strategy is that in the current global macroeconomic landscape, this currency is a good place for investors who are chasing yield and can earn a nice return.
A carry trade is when you buy a high-interest currency against a low-interest currency. So it makes sense to go long with high yielding currencies as your broker will pay you the interest difference between the two currencies – as long as you are trading in the interest positive direction. Besides the interest differential gains, you can also benefit from the actual exchange rate fluctuation if you’re trading in the direction of carry interest and if the exchange rates appreciate.
The underlying SARB’s tone has been hawkish after the July 2015 rate hike by 25 basis points to 6%. Comparing that globally, during this year alone, more than 25 Central Banks have cut the interest rates at least one time. This highlights how attractive the South African Rand can be to foreign investors.
The market expectation is for another hike of 25 basis point September has also grown considerably after recent moves from SARB. Apart from South Africa and Brazil, no other Emerging Market Central Bank (see Figure 2) has the intention to hike rates; one the contrary they all have been lowering the interest rates in order to stimulate growth in their economies. South Africa interest rates are forecasted to hit 11% by September 2016.
On the other hand, if we look at the global interest rates spectrum, interest rates expectations have been downgraded and even current FED interest rate normalization cycles will be very slow (by historical standards). However, one question still remains unanswered: whether or not investor appetite for yield can downplay the spike in global risk aversion, brought by the turmoil in China and spur the demand for the South Africa Rand. When one employs a carry trading strategy, the main objective is to capture the yield and not merely to profit from the exchange rates appreciations. This doesn’t mean, however, that you shouldn’t factor in the exchange rates movements because your carry trades can be quickly diluted by a strong trend.