Outlook for NOK ahead of monetary policy change

Summary:

• Market does not price in a rate hike in September

• Interest rate market favours the stronger krone against the US dollar

• USDNOK seems to be well above its ‘fair value’ based on Brent prices

• Technical analysis points to limited space for further rally

It was March 2016 when the Norges Bank decided to change rates for the last time, cutting the deposit rate by 25 basis points to 0.5%. After more than two years the Norwegian policymakers are setting the stage for a rate increase which could take place as soon as September. Meanwhile, market participants do not seem to share the hawkish tone of the central bank assigning limited odds to see an increase next month even as we have not been offered evident reasons to doubt the monetary tightening. This analysis focuses on major points why the Norwegian krone could be at a turning point.

Based on FRA-implied odds one may notice that traders price in less than 10 basis points increase in September, and a notch more than 17 basis points until the end of the year. Source: Bloomberg

Let us begin with the newest inflation data for July which came in well above expectations. This is especially true when we take a look at core price growth. Notice that while Norwegian numbers surprised to the upside, we cannot say the same about the Swedish inflation report as it basically failed to strengthen the case for the first rate increase during the last quarter. The Norges Bank will have the last chance to steer market expectations this Thursday when the monetary policy meeting will be held. Taking into account the latest developments we do not see any reasons for the central bank to deviate from its course. Do notice that the Norges Bank said in June that while “underlying inflation was lower than the inflation target, rising capacity utilisation implied an increase in price and wage inflation further out”. Indeed, we got such a rise in the last month when core inflation jumped to 1.4% from 1.1% in annual terms smashing the consensus pointing to just a modest improvement to 1.2%. Then, the Bank also reiterated that “they key policy rate would most likely to be raised in September 2018”. As per inflation developments we think that market participants underprice an interest rate rise. Nevertheless, looking for any excuses for the central bank to push back a rate increase, one may single out heightened external risks which have surfaced lately. Most of them are directly related to Turkey, albeit we do think these risks could be sufficient to derail the increase next month.

The bond market has lately begun favouring the stronger krone as the rally on the USDNOK may have gone too far. Source: Bloomberg

The relatively low likelihood of monetary tightening in September is also seen in the bond market even as the longer end of the curve. As depicted above, the 10Y yield spread between Norwegian and US notes has turned lower recently while the USDNOK has simultaneously beefed up. This scheme could suggest that the latest jump, driven particularly by safe-have seekers, may have gone too far and this seems to be especially true when we take into consideration what the Norges Bank is going to do. Given that the NOK, similarly to the SEK, is trading well below its long-term fair value, and the USDNOK has recently approached its important technical levels we reckon that from this perspective the short looks encouragingly. That said, notice that rising borrowing needs in the United States put upward pressure on yields constituting a downside risk for the NOK strengthening.

The NOK seems to be undervalued based on Brent prices. Source: Bloomberg, XTB Research

Last but not least, as everybody well knows the Norwegian economy relies on oil, even if this dependence is to be reduced in the future. Therefore, making an effort to evaluate the Norwegian currency one cannot miss out oil prices. We carried out the simple regression analysis based on weekly observations of USDNOK and Brent prices over the course of the past 5 years. The results have been illustrated at the chart above. As one may see, from this angle the USDNOK appears to be trading well below its ‘fair value’ when relying solely on Brent prices. Note that the relationship between the spot rate and values implied by the model has broken down at the beginning of April, this is exactly when the US dollar has started showing its dominance. Thus, the latest rally on the USDNOK may have been driven solely by the strong greenback while traders have tended to underprice an impending rate hike in Norway.

The USDNOK has reached its remarkably important resistance placed in the neighbourhood of 8.40, and it has been unable to storm higher. This area is also underpinned by the upper bound of the long-term descending channel, hence one may suppose that bulls might find it harder to break through this line. Putting all the above-mentioned together we recommend taking a short at the market price with the target at 7.70 and the stop placed at 8.60. Source: xStation5