Niels Christensen

Danish central bank on Jan Størup Nielsen track towards first rate hike Morten Hassing Povlsen Nordea Research, 07 October 2015

The Danish krone is stable and currency reserves are being steadily reduced. Today the central bank resumed its government bond issuance and can now start the final phase: to normalise interest rates. We still see the first rate hike towards year-end, but it is hard to gauge how much is priced into the Danish money market. Intervention gradually slowing

In September the central bank sold foreign currency for DKK 22.1bn. This reduced Denmark’s currency reserves to DKK 514bn following a peak of more than DKK 737bn in March. Although the intervention in September was very significant by historical standards, it was actually the lowest monthly purchase since early April. And with the intervention likely concentrated in the first two weeks of September, it suggests that the bank is far less active in the FX market now than previously.

EUR/DKK – the central bank's intervention

nexus.nordea.com/research Next step – independent rate hike

After a pause of more than eight months the central bank today auctioned its first government bonds since January. Total sales were DKK 5.23bn, where the 10Y bond was well received (sales of DKK 4.38bn, b/c of 2.15), whereas the 1Y bond sold somewhat less (sales of DKK 850mn, b/c of 10.35). The auctions should pave the way for improving liquidity in Danish government bonds. Read more in our research note on the government bond auctions. The auctions also mark the second-last step in the normalisation process pursued by the central bank since late spring. The final step is an independent rate hike. In our baseline scenario, we see the bank initiating this towards year-end by raising the CD rate by 10 bp.

This should signal a gradual narrowing of the interest rate differential versus the ECB, bringing the Danish CD rate on a par with the ECB’s deposit rate by end-2017. A delay to this process could occur if the ECB expands its ongoing purchase programme. Such further easing of the ECB’s monetary policy will, all else equal, generate pressure for a stronger Danish krone. This also underlines our view that given the large and consistent current account surplus, the underlying appreciation pressure will remain considerable for a long period.

Stable currency first priority

The precondition for further reducing currency reserves and narrowing the interest rate differential to the ECB – an independent Danish rate hike – is that this can be done without triggering large and unwanted EUR/DKK fluctuations. Krone stability is the first priority.

Over the last four months EUR/DKK has traded in the 7.4550-7.4650 range. In July and August the cross mainly fluctuated around 7.4630 and consequently traded above the parity rate at 7.46038. During September EUR/DKK slipped below the parity rate to trade in a narrow range around 7.4600 in recent weeks.

The EUR/DKK setback fits pretty well with the slowing intervention – the central bank selling EUR/DKK. nexus.nordea.com/research We judge that the central bank is fairly pleased with EUR/DKK trading in the 7.4550-7.4650 range; and that Danish interest rates will be normalised at a pace that will not trigger any major krone appreciation. The bank will consequently avoid an isolated rate hike causing the currency to strengthen to an extent that will necessitate renewed intervention and foreign currency purchases to prevent EUR/DKK declines.

Against this background, we do not anticipate a rapid normalisation (hike) of the CD rate. The fact that Danish interest rates are below the Euro-zone level implies that discounts in the forward market will be eliminated in tandem with a narrower interest rate differential.

And in case of renewed upward pressure on EUR/DKK, the bank can raise rates faster to support the krone instead of continuing to sell foreign currency and reduce its currency reserves.

EUR/DKK – stability close to parity

nexus.nordea.com/research EUR/DKK – 12M forward discount

Hard to tell how many rate hikes are priced in

It is important to acknowledge that at the moment it is hard to tell what the short end of the Danish curves prices in in regard to rate hikes when looking at: the large differential between the current account rate of 0% with current account limits of DKK 63bn and the CD rate of -0.75% makes the unsecured T/N rate highly volatile. Over the past week the T/N rate has averaged -0.46%; this is due to low weekend fixings. In addition, Danish interbank trading at the T/N rate has also been lower recently.

Even so, many use CITA swaps (with the T/N rate as the underlying fixing) to assess how much is priced in as regards the CD rate. We strongly advise caution when using CITA swaps to assess market expectations for the central bank as a rate hike will not necessarily feed through on a 1:1 basis to other Danish short-term rates.

The market is pricing that 3M CITA and 3M Cibor will rise 10 bp within four months, whereas the spread between 3M Cibor and 3M CITA is priced to remain just below 30 bp. Judging by 3M CITA levels, this is clearly a poor indicator of the CD rate and the current account rate.

nexus.nordea.com/research With a rate hike, the T/N rate could on average become slightly higher, but equally important it might become less volatile.

Market pricing in higher 3M rates in DKK

Money market pricing in higher DKK rates and wider DKK-EUR spread

While Danish money market fixings are priced to rise gradually, money market fixings in EUR are priced to fall further from the already historically low levels. 3M EUR OISs are priced to fall to around -0.2%. This implies that a further reduction of the ECB’s deposit rate is priced in, something we do not expect. 3M Euribor is also priced to fall slightly over the next year. We think the pricing of EUR fixings at the short end is too low and recommend locking in a fixed rate at the short end of the EUR curve.

Overall, DKK-EUR spreads are set to widen at the short end of the curve, taking the 3M Cibor-3M Euribor spread above 30 bp in two years from below 0% today. This spread seems too high as it peaked at 24 bp in 2014, but the spread has not been above 30 bp since mid-2010.

nexus.nordea.com/research 3M EUR and DKK rates and spread

nexus.nordea.com/research

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