The Dollar Milkshake Theory: The Rand’s Date At Milky Lane

The Milky Lane first date was part of every young South African teen’s playbook back in the day and I am sure you can recall the sense of accomplishment when you bought that first milkshake for a crush. For the ladies, this was when you started to refine the art of wrapping that R50 bill-burning boy around your pinkie finger (these were the days when R50 had you and your lover covered). The rand also has a date at Milky Lane on the calendar, and this date is with the Dollar Milkshake theory…

Brent Johnson, CEO of Santiago Capital, penned his Dollar Milkshake theory back in 2018 and unfortunately, it has nothing to do with the tasty treats at Milky Lane. Johnson’s theory states that the global central banks created a big “milkshake” of liquidity with the unprecedented quantitative easing after the 2008 global financial crises. This era of easy money (which I like to refer to as the start of casino capitalism) injected roughly $30 trillion of reserves into the global economy since 2008. The Dollar Milkshake Theory is an economic theory that predicts the United States dollar will continue to strengthen against other currencies. The theory is based on the fact that the central banks of many foreign countries issue debt in US dollars, as well as hold debt on their balance sheets in US dollars.

Another tsunami of liquidity hit the global markets in 2020. The Fed transitioned from easing to tightening monetary policy roughly a year ago when they started raising the federal funds rate to cool inflation and reel in some of that liquidity. In doing so, the Fed is metaphorically using a big straw to suck up liquidity from global markets which sent the DXY (dollar index) to 20-year highs last year. The dollar strengthens as the Fed downs this dollar liquidity milkshake, leaving other countries with a major brain freeze, particularly those with dollar-denominated debt.

The cookie begins to crumble rapidly as debts denominated in dollars globally become more expensive as countries’ local currency depreciates against the dollar. The increased dollar debt costs diminish the countries’ ability to pay down their dollar-denominated debt which amplifies investors’ fears and causes even more capital to flee. Additionally, risks of a global recession, like we are seeing now, attract even more capital to the US given the US dollar’s safe haven status.

South Africa is feeling the effects of that brain freeze and the rand is not enjoying its time at Milky Lane with the dollar. Apart from the Fed enjoying its liquidity milkshake, there are numerous local factors that are accelerating capital flight out of South Africa. In the SARB’s Financial Stability Report of May 2023, the SARB highlights numerous idiosyncratic risks hitting the rand and SA’s financial stability. The most significant risk is SA’s electricity uncertainty and deteriorating rail and port infrastructure. In connection with the declining infrastructure is the amount of State-Owned Enterprise (SOE) debt relative to SA’s emerging market peers. SA has one of the highest SOE debts among emerging market currencies and as the government takes over the SOE debt the local taxpayer and bond investor will have to foot the bill.

The other major idiosyncratic risk, which is still fresh to market participants, is the deterioration of South Africa’s diplomatic relations with the US following the comments by the US Ambassador to South Africa on 11 May 2023. Despite the claims being baseless, SA’s non-alignment stance in the conflict in Ukraine is hugely rand-negative. The SARB highlighted the risk of secondary sanctions which could be imposed on SA due to the neutral standpoint. US Secretary of the Treasury, Janet Yellen, also explicitly warned South Africa when she visited back in January this year, to take the sanctions imposed on Russia seriously.

Coupled with the Financial Action Task Force greylisting of South African financial institutions in February this year, the potential implications for the South African economy are severe. If secondary sanctions are imposed on South Africa, it will make it impossible to finance any trade or investment flows or to make or receive any payments from correspondent banks in US dollars. Furthermore, more than 90% of SA’s international payments, in whichever currency, are currently processed through the Society for Worldwide Interbank Financial Telecommunication (SWIFT) international payment system. Should South Africa be banned from SWIFT because of secondary sanctions, these payments will not be possible.

The above-mentioned factors have led to a mass exodus of funds out of South Africa and as mentioned earlier, local investors will have to absorb the sell-off from foreign investors. The proportion of South African Government Bonds held by foreign investors has declined from 42% in April 2018 to 25% in February 2023.

To conclude this negative Milky Lane session, unless there is a rapid rise in the price of precious metals, particularly platinum, I cannot see South Africa attracting foreign funds soon. This will unfortunately see the USD/ZAR pair climb higher and rates above R20/$ seem inevitable. A break below the 2020 high of 19.35 will however allow the rand to pull the pair towards the pair’s 50-day Moving Average rate currently sitting just above 18.50. It is worth noting that technical indicators are currently suggesting that the rand is heavily oversold but in light of the current fundamental risks to South Africa,  the markets will not care too much about the technicals.


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