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South African inflation data was due for publication yesterday. Consumer prices in South Africa rose 6.3 pct YoY in February of 2017, following a 6.6 pct gain in January, matching market expectations. It was the lowest inflation rate since September of 2016, as prices rose less for food and non-alcoholic beverages and household contents and services.
Above all the base effect for food, where prices had risen notably a year ago due to the drought, as well as the appreciation of the Rand since November 2016 which has dampened the price pressure for imported goods, is pointing in that direction.
At the same time, the servicing of the notably risen government debt and public sectors salaries takes up a growing share of public spending. The eroded financial situation of state-owned companies that increasingly require financial guarantees threaten to cause a rise in the budget deficit.
However, with a view to international investors, Finance Minister Gordhan wants to sticks to his consolidation course. For the rating agencies, the stabilization of public finances is an important pre-requisite for the country to be able to maintain its rating (one step above junk status).
Although ZAR appreciated since the beginning of the year on the back of a weaker USD, downside risks to ZAR will reappear as the political risks become more prevalent for ZAR again. We, therefore, expect to see a correction towards 13.50 in USDZAR sooner or later.
While the changed political landscape suggests the medium-term picture is shifting more positive, we remain tactically bearish ZAR.
Subsequently, on the option trade front among EMFX, we recommend positioning longs in USDZAR as the South African significantly overshooting fundamentals –
A naked long USDZAR portfolio that doesn’t make us buying USD vols especially after dovish Fed. Instead of naked vanilla call form, we suggest call spread structure for the 2M horizon, optimizing strikes for leverage.
In USDZAR, the 1M-2M ATM spread is below average at +0.75, as 1M vols had remained relatively anchored and never softened significantly.
Therefore, the premium for owning US elections risk isn't punitive, and the short leg further mitigates the cost of gamma.
The above table explains how does the call spread is ordered in decreasing values of max payout/cost.
We find that skews aren’t steep enough vs ATM to allow for a wide range of strikes to be efficient. In order to ensure more than 50% discount to the outright vanilla, and a max payout/cost higher than 3.5:1, one needs to choose a combination of long 40D vs 25D.
The call spread achieves a 55% discount to outright call and a max payout/cost ratio of 3.7:1 (mid values).
