Today's Talking Point
GB Manufacturing production y/y: Dec
Analysis: The UK manufacturing sector may post its first y/y contraction since February 2021 for December, with consensus pencilling in a minor drop of 0.3%. Rising COVID cases, which resulted in some new restrictions, as well as supply chain issues and higher commodity prices, will all have weighed on the sector's performance at the end of the year. Some of these factors still persist, suggesting that the sector will unlikely be able to grow at levels seen earlier in 2021, even when taking base effects into account. Nevertheless, the outlook for the economy is still relatively strong and we should see the sector rebound in the near term.
Following a strong advance earlier in the week, the ZAR ran out of steam and gave back some of its recent gains on Thursday. The local unit depreciated 0.60% after bouncing off of its 100-session moving average, as the market booked some profits and looked to reassess its valuation after this week's move. The ZAR's recent rally away from the R16.0000/$ mark has effectively reopened the door for the bears, who had previously pushed the market to its limits.
The fact of the matter is that the US Federal Reserve is still expected to begin a new rate-hike cycle in the current quarter, with both the Fed Funds Futures and the Overnight Index Swaps markets pricing in an 85%+ probability of rates lift-off in March. While this week's events were triggered by an easing of quantitative tightening expectations and more general correction of Fed monetary tightening pricing, the prospect of a new rate-hike cycle means underlying anxiety will remain, which could keep the market on high alert in the weeks ahead.
That being said, Fedspeak this week has emphasised that it would not allow monetary tightening to derail the economy's expansion, which has brought an end to the 10-year UST yield's recent uptrend. In reality, whether the Fed can, in fact, curb inflation effectively without slowing the US economy is unlikely, but the market has nevertheless welcomed its pledge to attempt doing so and at least maintain some focus on economic growth.
Note that FRAs rediscovered some paying interest yesterday, implying there is some healthy demand underpinning rates, with many in the economy generally exposed to interest rate risk. The 1x4 FRA as it stands is pricing in a little over 30bp worth of rate hikes, suggesting that the 27th of January rate decision is a live one from the market's perspective. Around 180bp is priced into the 9x12, which delivers from mid-September to December, which seems excessive given the potential effect on an already-constrained economy that has more structural suppressing factors than cyclical drivers of rates. The USD-ZAR also found a base at its 100-SMA, which will have reduced the attractiveness of receiving rates at the margin.
While low inflation risk, a relatively stable ZAR, reduced levels of business investment, and negative real credit growth reduce the risk that the SARB ultimately hikes as aggressively as the Quarterly Projection Model (QPM) is pricing in, some pre-emptive tightening seems likely. The balance of risks is tilted towards a weaker ZAR if the Fed hikes, while the policy rate is very accommodative at current levels. Another 25bp rate hike would take the repo rate up to 4%, leaving SA's current real interest rates around -0.5% if the SARB's forecast for 4.5% average inflation in 2022 proves correct. At least another 100bp could be expected in this cycle, while it is worth highlighting the low prediction capacity of the QPM since its inception.
However, note that another risk to inflation has started to emerge as Eskom argues for higher electricity prices. The power utility has requested a 20.5% price hike, which makes up part of the "electricity and other fuels" portion of the housing and utilities portion of the CPI index, with electricity specifically carrying a 3.75% weight in the headline index. It follows that if granted, electricity will buoy headline CPI by 70-80bp in the year ahead. To what degree this will alter systemic inflation risk is up for debate, particularly given a low overall level of money supply growth that reduces the space for higher prices to filter into broader goods and services prices.
Download full report