Rand most vulnerable currency in EM (Monthly Outlook, 1-3 months)

The South Aferican rand has been one of the most vulnerable currencies in EM from this recent bout of risk aversion. Since June, risk aversion increased from the lows observed in the past two years to the highs since early 2012. 

"We believe this has been mainly due to an unexpected increase in foreign demand for local bonds. The backdrop for this has been investors' expectation that SARB credibility will succeed to keep local bond yields well-behaved", says RBC Capital Markets.
Foreign demand for local bonds using a zscore of JSE Securities Exchange data of foreign buying. 

"The foreign demand turned net positive around March this year. There was a meaningful pick-up towards June. This could be due to a combination of factors. First, SARB has voiced concerns that the rand was reaching meaningful undervaluation. Second, despite low headline inflation observed at 4.5% y/y in April, the central bank maintained vigilant bias. It initiated a rate hike cycle back on July 23 with a 25bp hike, from 5.75% to 6%", estimates RBC Capital Markets. 

Higher risk aversion may have taken investors wrong footed. Most seem to have opted to keep local market exposure in South Africa while reducing duration exposures in Brazil and Mexico. In fact, forward-forward yields in the local swap market in South Africa are 160bp higher than Mexico. Nevertheless, a steep yield curve in both markets also provides an attractive opportunity to buy USD/ZAR against bond exposures and run a positive carry position.

"We believe that an additional 25bp hike at the September 23 meeting will help anchor the currency and bring it back below 13.00", added RBC Capital Markets.