Norges Bank Dilemma Too early to rule out monetary policy easing

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1 Investment Research General Market Conditions 11 August 2016 Norges Bank Dilemma Too early to rule out monetary policy easing Inflation has returned as a key factor for Norges Bank s rate setting which alongside accelerating house prices have casted doubt over the outlook for additional rate cuts. We think the re-pricing of monetary policy is premature especially given the latest rise in Nibor interbank rates that has driven an implicit monetary tightening in Norway. The coming month s data will be crucial. At this stage we still think NB will increase NOK liquidity over the coming months and/or cut the sight deposit rate in September. In June NB guaranteed a rate cut in September. If we look at the various factors that affect the rate path this would only suggest a marginally higher rate path. A substantial change in the risk assessment of inflation and the housing market could justify leaving rates unchanged. However, unchanged policy would not only ratify the monetary tightening from higher Nibor fixings, but would also drive additional monetary tightening via substantial NOK appreciation. FX and FI strategy: we think risks are asymmetrically skewed towards lower NOK rates and a weaker NOK. From a risk reward perspective we therefore find value in receiving 2Y2Y outright or selling the front FRAs. One could consider receiving (selling) 6M FRAs given the significant widening between 3M and 6M NIBOR. In FX markets we look to buy EUR/NOK when current NOK-momentum fades. Chart 1: NB has seen above-targetinflation as a temporary phenomenon Inflation returns as key factor for Norges Bank s rate setting The July inflation print was a game changer. Since the oil price collapse in 2014, Norges Bank (NB) has primarily focused policy on stabilising domestic growth and employment within its flexible inflation mandate. NB has over the last year accepted above target inflation as the rise has been driven by a weaker NOK and higher import prices - since the weaker wage and demand outlook has been expected to eventually drag inflation lower, cf. chart 1. July core inflation of 3.7%, however, not only surprised strongly to the upside, both relative to Norges Bank s 2.5% inflation target and July inflation forecast of 2.9%, but the details also showed that domestic price pressures have picked up which creates concerns about price-cost spirals., the print has therefore brought back inflation as a key factor for NB s rate setting. Indeed the July print alone should (from a historical perspective) lift NB s rate path in September by close to a full hike which is why a substantial amount of rate cut expectations has been priced out in NOK rates over the last days. While it may seem absurd to talk about rate cuts for a central bank facing rising above target inflation, we nonetheless think it is premature to price out the probability of a September cut. Chart 2: But risk of domestic pricecost spirals has increased Chart 3: NB facing house price and inflation worries Chart 4: amid weak growth and implicit monetary tightening Chief Economist Frank Jullum fju@danskebank.dk Head of FI Research Arne Lohmann Rasmussen fju@danskebank.dk Analyst Kristoffer Kjær Lomholt klom@danskebank.dk Important disclosures and certifications are contained from page 5 of this report.

2 NB guaranteed a September cut At the last monetary policy meeting in June NB left rates unchanged, lifted the rate path but still suggested an implied 100% probability of a 25bp September rate cut conditioned on economic data developing in line with the central bank s projections. Chart 5: June rate path suggested a 100% probability of a September cut Since then domestic indicators have on balance been roughly as expected and still suggest an improved private sector growth outlook, albeit from weak levels. While goods consumption remains weak, leading indicators for manufacturing production suggest an improved outlook. Yet substantially higher survey indicators have at this point not materialised in hard data and July manufacturing production disappointed to the downside. Perhaps the strongest data points in Norway are the NAV (i.e. registered) labour market reports that reveal, not only steady gross unemployment levels on a national level, but also drops in the number of unemployed people in some non-oil dependent areas, including Oslo. Also the rise in new job vacancies is encouraging. A significant development since the June meeting has been the 15% decline in the oil price. Importantly, cost reductions on the Norwegian shelf has reduced break even costs for the big oil projects and the oil price would have to drop an additional 15-20% - which we don t expect - to have significant effect on Norwegian oil investments and thereby economic growth. Chart 6: Private sector growth outlook has improved but remains weak Chart 7: Stabilising unemployment reduces the tail-risk Chart 8: yet the latest oil price drop partly counters this but risk assessment challenges NB s dovish bias NB s flexible inflation mandate includes a robustness criterion that is formulated as monetary policy should seek to mitigate the risk of a build-up of financial imbalances. While financial imbalances is loosely defined it has over the last years primarily been related to the substantial household debt and the housing market. The last months house price increases have been much higher than NB expected (chart 9). While macroprudential policies have already been enacted it does challenge the degree to which NB can maintain a dovish bias since accelerating house prices increase the Norwegian economy s vulnerability to higher rates and/or external chocks. It is, however, important to emphasise that the marked rise in house prices especially in Oslo - partially can be explained by a tight supply. In this respect the latest rise in new dwelling starts should be comforting both in terms of growth and in limiting further house price increases. Importantly, while the surprise inflation print would suggest a 20-25bp higher rate path over the coming years it is very difficult to quantify the NB board s subjective risk assessment of the robustness criterion. Indeed the last monetary policy meetings have shown that NB has shifted towards a more cautious stance as the sight deposit rate approaches a lower bound (which they explicitly has said is not necessarily zero). NB has also explicitly said that the more cautious approach has meant that changes to fundamentals will have smaller impacts on the rate path than usual. Chart 9: House price increases have been much higher than NB expected Chart 10: a development especially driven by Oslo 2 11 August

3 yet Norway still faces monetary tightening if policy is left unchanged If NB does not cut rates in September monetary policy will implicitly have tightened in Norway, as the interbank money market rates have risen substantially over the last month. The reason for the rise is found via the way the benchmark Nibor rates are fixed combined with tight interbank NOK liquidity. In Norway the benchmark NIBOR rate fixings are based on FX forwards as specified by the rules laid down by Finance Norway. Specifically, a panel of six banks report daily fixings backed out from USD/NOK FX forwards using individually estimated costs of borrowing unsecured USD in the interbank market (for more info see box to the right and Additional Guidelines for panel banks Nibor submissions). Chart 11: Nibor fixings have been pushed higher Chart 12:.. by tight NOK liquidity and a higher USD shortage premium NIBOR fixing methodology NIBOR fixings are backed out from the USD/NOK FX forward via the covered interest rate parity (CIP), NOK 1 i F S, such that: NIBOR = FX USD 1 i Forward (in %) + USD rate As Norges Bank aims at keeping reserves within a fixed interval, the relatively tight NOK liquidity means that a wider US FRA/OIS spread will have a tendency to push NIBOR fixings higher, cf. chart below. In practice, this has the important implication that NIBOR fixings are not only influenced by domestic monetary policy expectations but also by international conditions even if this is not expected to influence the domestic interbank market. As chart 12 shows, NIBOR rose during the European debt crisis as a result of Eurozone money market stress. Over the last years the NIBOR-policy rate spread has again risen as a result of first ECB QE and now the US money market reform (see The US Money Market Reform The scandi angle, 9 August) both widening the relative USD-shortage premium, cf. mid chart below. In this respect tight NOK liquidity has amplified the effect on Nibor fixings via the FX swap due to the high term-demand for NOK in the interbank market. NB has since October 2011 set a reserve target of NOK 30-40bn, which it controls via open market operations. To avoid a situation where large and unforeseen changes to the state s balance at NB (e.g. tax payments, foreign debt repayments) leads to random costs for banks, the sum of banks current account limits are set at NOK 45bn. A higher reserve target could therefore lead to lower Nibor fixings. Chart 13: which implicitly has given close to a full 25bp rate hike Chart14: NOK corridor system 3 11 August

4 and it is therefore too early to cancel our September rate cut call If we quantify the factors that NB usually refer to when modifying the rate path disregarding subjective risk assessments then the September rate path should be raised only marginally, thereby implying 1) Either a September rate cut and/or 2) NB directly addressing tight NOK liquidity In this respect it is also important to remember that NB is very aware that an unchanged policy would not only ratify the implicit monetary tightening described above, but would also lead to a substantial NOK appreciation resulting in even tighter monetary conditions. Indeed it is our impression that foreign investors generally perceive the NOK as fundamentally heavily undervalued. While we agree on this we do want to highlight that the relative development in unit labour costs suggest that the room for short-term NOK appreciation given weak growth - is much more limited than what a long-term purchasing power parity approach would indicate (chart 16). Key Releases 1) Oil investment survey, 24 August 2) Q2 GDP release, 31 August 3) House price release, 5 September 4) August inflation, 9 September 5) Regional Network Survey, 13 September Source: Bloomberg, SSB, Norges Bank Chart 15: The NOK is now stronger than NB projected in June Chart 16: Relative unit labour costs suggest reduced upside NOK potential Chart 17: EUR/NOK has become borderline cheap according to our short-term financial model Having said this we do recognize that the probability of additional rate cuts have fallen significantly on the back of the last inflation and housing market releases which leaves the coming month s data releases as pivotal ahead of the NB meeting on 22 September. In particular we want to emphasize 5 key releases (see table in margin). Chart 18: Positioning suggest speculative community is neutral on NOK Given our expectations for these releases we decide to leave our call for a September cut unchanged. However, should NB decide to address tight liquidity and rising Nibor fixings in the money market (e.g. by raising their reserve target and current account limits) ahead of 22 September we would interpret this as an implicit rate cut in which case we would change our September call to unchanged. FX and Fixed Income Strategy We think risks going into the September NB meeting are skewed towards lower NOK rates and a weaker NOK. From a risk reward perspective we therefore find value in receiving 2Y2Y outright or selling the front FRAs. One could consider receiving (selling) 6M FRAs given the significant widening between 3M and 6M NIBOR. In FX markets we look to buy EUR/NOK when current NOK-momentum fades (chart 17). We do, however, want to emphasize that positioning seems much more balanced now (chart 18) which suggest EUR/NOK could move lower short-term still. As a result, one could alternatively consider to position for a move higher via option markets. According to our volatility models short-dated NOK volatility looks borderline cheap (chart 19) which makes long vega positions attractive, e.g. long 2M EUR/NOK call spread. Source: Norges Bank, Danske Bank Markets Chart 19: Front NOK volatility looks borderline cheap Currency pairs Scandies 2W 1M 3M Source: Danske Bank Markets 12M EUR/NOK Neutral Neutral Neutral Neutral EUR/SEK Neutral Neutral Neutral Neutral USD/NOK Cheap Neutral Neutral Neutral USD/SEK Cheap Cheap Neutral Neutral NOK/SEK Neutral Neutral Neutral Neutral 4 11 August

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