Since Ben Bernanke suggested that the US Federal Reserve was starting to consider slowing down its asset purchase program (QE), markets have been trying to price this in. The difficulty has always been in the timing of the ‘lift-off’ as the Fed has insisted that it all depends on the data.
However, Janet Yellen’s latest testimony before the House Financial Services Committee a few days ago reinforced market expectations for lift-off in September. Since then, the news cycle has been dominated by what this could mean for the US, European and Asian financial markets. Very little attention has been given to the potential impact of the Fed raising rates on African equity and currency markets.
Over the past five years we have seen an improvement in the economic conditions in most African frontier markets coupled with anaemic growth rates in the US and in Europe, which has led investors to look to debt and equity instruments on African frontier markets for yield and sustainable returns. The result of this has been so called ‘hot money’ flowing into these markets, especially equities.
The bulk of the money that has flowed into African equity markets has found its way to the likes of Kenya, Nigeria and to some extent, Zimbabwe. This ‘hot money’ is likely to cause some volatility in September should the Fed raise rates. Over 50% of the turnover in these markets is attributed to foreign institutional investors from Europe and the US which means they are very sensitive to the actions of the Fed.
To get a sense of what the market is expecting in September, the two month Non-Deliverable Forwards (NDF) are a good indicator of expectations.
The Kenyan shilling: The chart above shows that the Shilling has weakened by nearly 12 per cent this year and the expectation is a further devaluation by nearly 2 per cent in the next two months.The shilling recently breached the 100 level against the US dollar which some technical analysts regarded as a psychological point. Apart from the market pricing in capital outflows post the Fed raising rates, the currency has also been reacting to domestic rising inflation and the high current account deficit. In the last two months alone, the Central Bank of Kenya has raised rates by 300 bps and is due to meet again in early August and the consensus suggests that the bank rate will raise its benchmark rate again.
The Nigerian Naira: The Naira this year has weakened by about 5 per cent. The main cause of this weakness has been the fall in the oil price since its June 2014 highs. Since then, the Central Bank of Nigeria has attempted to stem the weakness but has not achieved much success so far. Since June last year, the Central Bank has devalued its currency twice (in November ’14 and February ‘15) and now is resorting to limiting access to foreign currency on the official interbank market to importers which will likely have the effect of increasing the spread between the parallel market rate and the official rate (20 per cent spread at the time of writing). Such efforts will likely be insufficient in the face of oil prices falling and the Fed raising rates. The chart above suggests that an 8 per cent devaluation is on the cards in the next two months.
The Ghanaian cedi and the Egyptian pound are showing signs of possible weakening in the future but in the short term (next two months) their performance is likely dependent on the respective actions of their central banks. For Ghana, the recent inflows from the IMF has helped to bolster the government’s forex reserves position which has helped stem the cedi’s weakness. Similarly, the Egyptian Central bank has managed to control the pound’s weakness mainly on the back of the support of the Gulf Cooperation Council countries.
The chart above shows the expected devaluation over the next two to twelve months. Looking at the term structure of Shilling and the Naira’s NDFs, we can see the market’s expectations as far as 12 months out. The Naira will likely lead the weakness as it faces more pressure than the shilling. In part the Naira’s projected weakness is reflective of the market’s expectations of the oil price as well as the expectation of the Fed’s pace of raising rates over the next 12 months. The Shilling on the other hand is under some pressure for the next 12 months reflecting the ability of its government to deal with the current account deficit as well as the Fed’s rates policy. However, unlike Nigeria, Kenya is a beneficiary of low oil prices as it is a net importer of oil.
The dynamics of African currency trajectories over the next 2 to 12 months will be key in determining the performance of foreign investor funds that have exposure to African frontier equity markets- Kenya and Nigeria in particular. The extent to which the Fed raises rates poses an even bigger threat than the timing. At present, the markets seem to be pricing in a 25bps rise, a figure greater than this would mean greater capital outflows which would send ripple events in Africa’s frontier equity markets.