Norges Bank Preview 14 March 2016

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1 Norges Bank Preview 14 March 2016 A 25bp cut and a dovish bias, limited EUR/NOK upside Frank Jullum Chief Analyst Jostein Tvedt Chief Analyst Kristoffer Kjær Lomholt Analyst Investment Research Follow us on Important disclosures and certifications are contained from page 14 of this report

2 Main points At its meeting on 17 March, we expect Norges Bank (NB) to cut the sight deposit rate by 25bp to 0.50% for the following reasons. At the previous meeting in December, NB indicated a 60-40% probability of a March cut and......foreign rates are lower, the wage outlook is weaker, credit spreads are marginally higher and the output gap is somewhat larger than NB projected. Spot oil prices are roughly in line with expectations, although the forward curve is somewhat below the projection from December. On the other hand, the NOK has been slightly weaker than projected and February core inflation was 0.3pp higher than NB s forecast. However, we do not believe the effect on the rate path will be enough to counter the factors above. If we are right in our call, we also expect NB to indicate a dovish stance by lowering the rate path, signalling an 80% probability of a rate cut before Q4 16. The current rate path from December has a 44% implied probability of another 25bp rate cut before Q4 16. Main risk factor. The largest risk factor is that NB fully incorporates the wage expectations from the regional survey. If so, the rate path will include a 100% probability of another rate cut, with the likelihood of an even more aggressive rate path like the one presented in December Market pricing. We estimate that markets are pricing in roughly 75% probability of a 25bp March rate cut, an accumulated 30bp rate cut for the June meeting and an accumulated 46bp worth of cuts on a 12M horizon (the point where the most easing is priced in). FX. We expect EUR/NOK to rise on the announcement. However, market pricing limits the upside potential. We still look for an eventually lower EUR/NOK in 2016, although we see the biggest potential in H2. Fixed income. A temporary weakening of the NOK in the wake of the monetary policy meeting, may be an opportunity for foreign accounts to add unhedged positions in long-dated Norwegian government bonds. 2

3 Decision: Norges Bank set to cut rates by 25bp We expect NB to cut the sight deposit rate by 25bp to 0.50%. Back in December, the rate path suggested one rate cut in H1 16 (three meetings: March, May, June) and 44% probability of another rate cut in H2. Since then, we have seen the following. Global forward rates have fallen roughly 10bp for end-2016, 25bp for end-2017 and 40bp for end The effect on the rate path is around 50%, dragging down the path 5-20bp from Mainland GDP growth for 2015 has been revised down by 0.4pp. to 1.0 %, leaving a larger output gap going into 2016 than projected by NB. In addition, the oil investment survey point to a steeper fall in oil investments in 2016, subtracting c.0.2pp from GDP in 2016, pulling the rate path further down. Wage expectations, published in two different surveys by NB, seem to have fallen below 2.5 %, while back in December NB expected 2.8% in However, as wage negotiations have just begun, it could be premature to conclude the result at this time. We consider this to be the most important downside risk to our expectations. On the other hand, the import-weighted NOK has been around 0.8pp weaker than expected, pushing the rate path upwards by c.5bp. Also core inflation was 0.3pp higher than expected in March. This could push the rate path upward but just one month is probably insufficient to trigger a large effect on the rate path. Pages 6-13 illustrate the developments. As a result, we expect the rate path to be revised down, to a policy rate of 0.30 % from Q4 16, indicating c.80% probability of another rate cut before Q4 16. December MPR indicated 40-60% probability of 25bp March cut, markets price* c.75% probability * Estimated from stripped FRAs Larger-than-expected output gap 3

4 FX strategy: EUR/NOK slightly higher on announcement EUR/NOK: limited upside in base case If we are right about NB cutting rates by 25bp while signalling a 80% probability of a cut at the September meeting, EUR/NOK would rise on the announcement. However, the potential is limited given current market pricing (see page 3). The main risk factor for our call is a more aggressive/dovish rate path including at least a full rate cut in This would trigger speculation about negative rates in Norway, which would increase the upside potential to EUR/NOK in the short term. We see the risks of a sharp move lower in EUR/NOK on the announcement as limited. Indeed, NB is very aware of not triggering a significant NOK appreciation at this point of the business cycle together with the uncertainty related to the oil price. EUR/NOK strategy As the oil price is closely tied to global growth, the NOK is heavily influenced both directly and indirectly by global risk appetite (see chart on the right). The EUR s status as a preferred funding currency also leaves the cross vulnerable to changes in risk sentiment. Consequently, although the NOK is substantially undervalued from a long-term perspective, the short-term outlook continues to be closely tied to risk sentiment. Given the limited upside in our NB base case, we prefer to stay sidelined spot outright. Also, according to our models, EUR/NOK is trading close to fair value (see chart on the right). Alternatively, one could utilise the recent fall in volatility and our view on the balance of risk by buying a 1M EUR/NOK call spread. This strategy would benefit from a rise in both spot and volatility should NB present an aggressive rate path such as the one from December. Going into the meeting EUR/NOK is close to fair value according to our short-term financial models Source: Bloomberg, Macrobond Financial, Danske Bank Markets EUR/NOK remains highly sensitive to global risk appetite Source: Bloomberg, Macrobond Financial, Danske Bank Markets 4

5 Fixed income strategy: the market at present seems fair Norges Bank will probably deliver close to the market expectation We expect NB to cut the target rate by 25bp at the upcoming board meeting and to lower the forward interest rate projection marginally, i.e. basically in line with what the market discounts at present. We see limited risk-reward in being positioned for a surprise move (in either direction) by Norges Bank at the upcoming meeting. If anything, short-end interest rates may decline slightly, as the central bank will try to avoid making any hawkish comments in order to keep the NOK weak (see page 4). NOK FRA 3M SEP 16 is 0.70%. The trough at present is MAR 17 at 0.61%. The FRAs, thereafter, are below 0.70% until the start of At present the asset swap spreads at the long end of the curve are at fairly low levels. The spreads versus German peers are, from a short historical perspective, fairly high. A potential temporary weakening of the NOK in the wake of the monetary policy meeting may be an opportunity for foreign accounts to add unhedged positions in long-dated Norwegian government bonds. ASW NST477 (2025) and NST 474 (2021) Source: Danske Bank Markets Yield NST477 (2025) and spread vs German peers NST 477 NST NST Spread NO DE 10Y(RHS) Source: Danske Bank Markets 1,3 1,2 1,1 1 0,9 0,8 0,

6 The outlook (1/8) domestic economy The latest Regional Network Survey still points to zero growth in the private sectors. Adding the contribution from the public sector, this points to mainland growth close to 0.2 % q/q in Q1-Q2. This is marginally lower than NB assumed in December. Importantly, however, there are still no significant second-round effects visible, as growth expectations in most other sectors have marginally improved. Regional network survey still points to zero growth in the private sector in coming quarters Still no trace of significant second-round effects 6

7 The outlook (2/8) the oil price and oil investments Although the spot oil price has returned to levels expected in the MPR from December, the forward curve remains a bit lower. On the other hand, oil companies have reported lower breakeven prices on the portfolio of new projects, so tail risks seem lower than in December. Nevertheless, the latest oil investment survey still pointed to a fall in investments close to 14% y/y in 2016, around 3pp lower than expected in December. Spot oil price in line with expectations, forward curve below Another downward adjustment to oil investments is likely 7

8 The outlook (3/8) inflation March core inflation surprised on the upside, at 3.4 % y/y. While the main factor explaining increasing inflation is the depreciation of the NOK, there are no signs of domestic inflation cooling off. On the contrary, domestic inflation reached 3.0 % in March, up from 2.5 % in H2 15. NB will still argue that the rise in inflation is temporary and do not expect it to read this as a shift in trend. However, we believe the higher current level will push the rate path upwards. February core inflation higher than expected as import prices have been driven by the weaker NOK 8

9 The outlook (4/8) wage growth Wage expectations, published in two different surveys by NB, seem to have fallen below 2.5%, while back in December NB expected 2.8% in However, as wage negotiations have just started, it could be premature to conclude on the result at this point, especially as this implies negative real wage growth in Regional Network Survey points to lower wage growth...and so does the expectations survey 9

10 The outlook (5/8) money market and credit spreads Due to tighter liquidity, the Nibor spreads have been higher than assumed by NB. However, actual lending rates to households seem to have fallen as expected. Regarding the effect on the economy, the latter is most important. Tight liquidity has increased money market spreads......but lending rates roughly in line with expectations 10

11 The outlook (6/8) foreign demand and foreign rates Since December, the expectations of global central banks have fallen. Global forward rates have fallen roughly 10bp for the end of 2016, 25bp for the end of 2017 and 40bp for the end of This should contribute to a lower rate path. Foreign interest rates significantly below projections Increased global risks 11

12 The outlook (7/8) financial stability and house prices House prices continue to rise, albeit at a slower pace than expected by NB in MPR 4/15. However, housing inflation is still well above growth in nominal income and real prices seem stretched. Credit growth has been more in line with expectations but is also higher than growth in income, increasing the debt burden further from an all-time high. Financial stability remains an argument against cutting rates aggressively, albeit less so than in December. Credit growth has been slower than expected and house prices have increased 12

13 The outlook (8/8) the exchange rate Since the December meeting, the import-weighted NOK (I44) has on average been around 0.8% weaker than NB expected. In terms of the latest fixing that will be included in NB s MPR 1-16, the I44-NOK is spot on NB s Q4 15 projection. However, with the lower oil forward curve in mind (page 7), we expect the exchange rate factor to lift the rate path by 5-12bp over the forecast horizon. The NOK has been marginally weaker than projected, although the latest fixing is spot on NB s forecast Overall the exchange rate factor should lift the rate path Change in rate path, pp Effect on NB rate path of change in I44 forecast since 2011 Dec' Mar' y = x x Sep'15 R² = % -2.00% 0.00% 2.00% 4.00% 6.00% 8.00% 10.00% Source: Norges Bank, Danske Bank Markets Dec'14 Dec'15 Change in I44 forecast 13

14 Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S ( Danske Bank ). The authors of this research report are Frank Jullum (Chief Analyst), Jostein Tvedt (Chief Analyst) and Kristoffer Kjær Lomholt (Analyst). Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in this research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. The research reports of Danske Bank are prepared in accordance with the Danish Society of Financial Analysts rules of ethics and the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high-quality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from and do not report to other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Danske Bank is a market maker and may hold positions in the financial instruments mentioned in this research report. Danske Bank, its affiliates and subsidiaries are engaged in commercial banking, securities underwriting, dealing, trading, brokerage, investment management, investment banking, custody and other financial services activities, may be a lender to the companies mentioned in this publication and have whatever rights are available to a creditor under applicable law and the applicable loan and credit agreements. At any time, Danske Bank, its affiliates and subsidiaries may have credit or other information regarding the companies mentioned in this publication that is not available to or may not be used by the personnel responsible for the preparation of this report, which might affect the analysis and opinions expressed in this research report. See for further disclosures and information. 14

15 General disclaimer This research has been prepared by Danske Bank Markets (a division of Danske Bank A/S). It is provided for informational purposes only. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) ( Relevant Financial Instruments ). The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report. The opinions expressed herein are the opinions of the research analysts responsible for the research report and reflect their judgement as of the date hereof. These opinions are subject to change and Danske Bank does not undertake to notify any recipient of this research report of any such change nor of any other changes related to the information provided in this research report. This research report is not intended for, and may not be redistributed to, retail customers in the United Kingdom or the United States. This research report is protected by copyright and is intended solely for the designated addressee. It may not be reproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank s prior written consent. Disclaimer related to distribution in the United States This research report was created by Danske Bank A/S and is distributed in the United States by Danske Markets Inc., a U.S. registered broker-dealer and subsidiary of Danske Bank A/S, pursuant to SEC Rule 15a-6 and related interpretations issued by the U.S. Securities and Exchange Commission. The research report is intended for distribution in the United States solely to U.S. institutional investors as defined in SEC Rule 15a-6. Danske Markets Inc. accepts responsibility for this research report in connection with distribution in the United States solely to U.S. institutional investors. Danske Bank is not subject to U.S. rules with regard to the preparation of research reports and the independence of research analysts. In addition, the research analysts of Danske Bank who have prepared this research report are not registered or qualified as research analysts with the NYSE or FINRA but satisfy the applicable requirements of a non-u.s. jurisdiction. Any U.S. investor recipient of this research report who wishes to purchase or sell any Relevant Financial Instrument may do so only by contacting Danske Markets Inc. directly and should be aware that investing in non-u.s. financial instruments may entail certain risks. Financial instruments of non-u.s. issuers may not be registered with the U.S. Securities and Exchange Commission and may not be subject to the reporting and auditing standards of the U.S. Securities and Exchange Commission. 15

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