FX Edge Rules or discretion? A look at past rate hikes in Denmark

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1 Investment Research General Market Conditions 8 January 2019 FX Edge Rules or discretion? A look at past rate hikes in Denmark We look at 14 unilateral rate hikes in Denmark since 1999 to draw a picture of how Danmarks Nationalbank (DN) has responded to a weak DKK in the past. We find that FX intervention selling of FX reserves has preceded rate hikes, which have most often been of 10bp. FX intervention has been a necessary, but not sufficient, condition for a rate hike and there is no clear picture in terms of how much FX intervention triggers a rate hike. We expect DKK to strengthen over the course of 2019 and the need for FX intervention to recede. If we are wrong on this, we expect DN to intervene for at least DKK50bn before opting to hike rates unilaterally. We forecast EUR/DKK at in 6-12M and that the key policy rate will stay unchanged at minus 0.65% until we forecast the ECB will hike rates by 20bp in December. What has triggered unilateral rate hikes in the past? Following December s FX reserve data, which showed that DN had sold FX reserves for DKK12bn to cap EUR/DKK topside, speculation has mounted on whether a unilateral rate hike in Denmark is imminent. Below we look at the history of unilateral interest rate hikes in Denmark and DN s previous reaction function and put this into the current context. We include unilateral increases of the key policy rate along with implicit rate hikes. The latter we define as a tightening of the spread between key policy rates in Denmark and the euro area following a change in ECB policy rates. Since the introduction of the euro in 1999, DN has made 14 unilateral rate hikes, with five of these implicit rate hikes (see Chart 1 and Table 1 below for a complete list). Going forward, we simply refer to them as rate hikes. We can put the 14 hikes into two groups: one where the rate hikes can be characterised as a small adjustment of the policy rate spread between Denmark and the euro area and one where rate hikes followed extraordinary circumstances. Chart 1. FX intervention selling of FX reserves and unilateral rates since 1999 Note: Does not include FX intervention selling of FX reserves in December 2018 Source: Macrobond Financial, Danmarks Nationalbank Senior Analyst Jens Nærvig Pedersen jenpe@danskebank.dk Important disclosures and certifications are contained from page 4 of this report.

2 In the latter group, we include the 50bp rate hike following the Danish referendum on euro membership in September 2000 and the two 50bp rate hikes in October 2008 in the midst of the financial crisis. We do not go into further detail on these three instances in our analysis. 11 small rate hikes since 1999 The former group includes the remaining 11 rate hikes six explicit and five implicit rate hikes. On 10 occasions, DN hiked the key policy rate by 10bp and once it hiked 15bp. Hence, 10bp is the norm for a small adjustment hike the argument behind the deviation to 15bp back in 2014 was that it led to a return of the key policy rate to positive territory, i.e. 0.05%. Preceding the 11 rate hikes was a period of FX intervention, where DN sold FX reserves to cap EUR/DKK. The amount of FX intervention has ranged from DKK1bn to DKKK231bn. Three times, DN hiked rates after less than DKK10bn in FX intervention, four times DN sold FX reserves for DKK10bn-DKK20bn before hiking rates and the last four times it took more than DKK30bn to trigger a rate hike. When DN changes policy rates, the decision is outlined in a short press release, which sheds further light on the reason behind the decision. We have looked at the press release accompanying the twelve rate hikes analysed here. On all but one occasion, DN references FX intervention selling of FX reserves as an argument. Five times, DN further added higher short-term euro area interest rates relative to equivalent Danish rates as an argument for hiking rates. At one time, in 2006, DN further referenced portfolio outflow from Danish investors as a reason for hiking rates. Note DN did actually intervene the one time it did not reference FX intervention when hiking rates. FX intervention a necessary, but not sufficient condition Hence, historically, FX intervention has been a necessary condition for hiking rates, but not a sufficient condition. There have been other instances where DN has sold FX reserves without hiking rates afterwards. The most noticeable are July 2005 and September-October Then DN sold DKK12bn and DKK14bn in FX reserves, when EUR/DKK was trading above 7.46, but left policy rates unchanged. No unilateral rate hike coming Historical evidence points to two facts about DN s reaction function: 1) FX intervention precedes a rate hike and 2) that rate hikes most likely come in 10bp increments. Other than that, in our view, DN has used its discretion to evaluate the appropriate response in the current situation. On some occasions that has meant a little portion of FX intervention has triggered a rate hike, sometimes because market rates had started to diverge. On other occasions, DN has opted draw a lot on FX reserves before putting a rate hike on the table. As we have argued before (e.g. see DKK FX/FI Strategy - DKK headwinds won't trigger rate hike and FX Strategy - EUR/DKK climbs higher, but rate hike likelihood remains low), in current situation we expect DN to draw on the FX reserve by at least around DKK50bn if needed to cap EUR/DKK before hiking rates. We see several good arguments for such a strategy on DN s part. 1) DN has a large FX reserve to begin with and thus time to be patient in the current environment, where a sequence of temporary factors have weakened DKK. 2) Since DN hiked rates in 2016, it has bought DKK60bn in FX reserves. Drawing down the FX reserve would simply amount to reversing this inflow (similar to what DN did in 2015). 3) A wider EURDKK XCCY basis has increased the discount in FX forwards on short positions in EUR/DKK. FX intervention will tend to tighten basis as it lowers banks net position (i.e. tightens DKK liquidity). We estimate that DKK50bn in FX intervention could tighten basis around 6-7bp. 2 8 January

3 However, we think this is a hypothetical scenario, as we look for DKK to be strengthened vis-à-vis EUR once equity markets start to recover, a trade deal between US and China is agreed and global growth prospects start to improve. We forecast EUR/DKK at on 6-12M and for DN to keep its key policy rate unchanged at minus 0.65% until December, where we expect DN to mirror a 20bp rate hike from ECB. Table 1. The history of unilateral Danish rate hikes Date Rate change Total FX intervention (DKKbn) Comment in press release 08/06/ bp* 34 The interest rate increase should be viewed mainly against the background of the European Central Bank's raising of interest rates of 0.50 per cent. However, the Nationalbank raises the lending rate and the interest rate on certificates of deposit by a little more than the ECBs rate ncreases. The reason is that during recent months the Nationalbank has sold foreign exchange, and since 30 May for around DKK 10 billion. 29/09/ bp 11 17/02/ bp* 34 16/05/ bp 18 07/10/ bp 36 24/10/ bp 29 14/10/ bp 7 28/10/ bp 2 24/01/ bp 17 24/04/ bp 20 06/06/ bp* 1 03/12/ bp* /01/ bp 51 10/03/ bp* 14 Source: Danmarks Nationalbank The Danish fixed-exchange-rate policy will be maintained after yesterday's referendum. There has recently been some pressure against the Danish krone. This has resulted in short-term interest rates that are significantly higher than the Nationalbank's official interest rates, and intervention in support of the krone by the Nationalbank. In order to avoid uncertainty concerning the krone the Nationalbank's lending rate and the rate of interest on certificates of deposit are raised by 0.50 per cent to 5.60 per cent with effect from 29 September The discount rate and the rate of interest on the banks' current accounts with the Nationalbank remain unchanged at 4.50 per cent. The increase by 10 basis points is due to an outflow of foreign exchange in February, among other things as a result of Danish institutional investors' purchase of foreign shares and other securities. In accordance with the fixed-exchange-rate policy Danmarks Nationalbank has intervened to support the krone. The interest-rate increase is intended to make placements in kroner more advantageous. Danmarks Nationalbank emphasises that the outflow of capital does not reflect a weakening of the Danish economy. Since August 2007 the spread between Danmarks Nationalbank's lending rate and ECB's marginal rate has been reduced with basis points, thus the spread has more or less disappeared. In short periods of time the interest-rate spread has been negative. The development of the interest-rate spread has led to a weakening of the Danish krone, and in accordance with the fixed-exchange-rate policy Danmarks Nationalbank has intervened to support the krone. Since mid-september there has been an increase in ECB's marginal rate. This has reduced the spread between Danmarks Nationalbank's lending rate and ECB's marginal rate. Recently the interest-rate spread has been negative, which has led to an outflow of foreign-exchange. Danmarks Nationalbank has intervened in the foreign-exchange market to support the krone. The intervention has now reached a point which leads to Danmarks Nationalbank's increase of the lending rate. The size of the change in the interest rate reflects the need to reestablish a positive interest-rate spread. As a result of continued intervention to support the Danish krone, Danmarks Nationalbank increases the lending rate and the rate of interest for certificates and deposits from 5 per cent to 5.5 per cent with effect as from 24 October The interest rate increase is due to a raise in the short European market rates compared to the equivalent Danish market rates. This development has weakened the krone, and Danmarks Nationalbank has intervened in the foreign exchange market to support the krone. The interest rate increase is due to a rise in the short-term European market rates compared to the equivalent Danish market rates. The interest rate increase follows Danmarks Nationalbank's sale of foreign exchange in the market. The interest rate increase follows Danmarks Nationalbank's sale of foreign exchange in the mar-ket. The short term rates in the euro area which are higher than the equivalent Danish rates have increased. This increase Danmarks has Nationalbank tended to weaken keeps the Danish interest krone. rates un-changed due to sale of foreign exchange in the market since the beginning of April, the devel-opment in the market interest rates, and the Danish krone rate. Hence, the differences between the monetary policy interest rates in Danmarks Nationalbank and ECB widens. This will normally be reflected in the money market rates, which determines the Danish krone rate. The decision to leave rates unchanged is based on the sale of foreign exchange in the market since April The interest rate increase follows Danmarks Nationalbank's sale of foreign exchange in the market. The deci-sion to leave rates unchanged is based on the sale of foreign exchange in the market since the turn of the year. Note: * denotes an implicit rate hike defined as a tightening of the spread between policy rates in Denmark and euro area following a change in ECB s policy rates. 3 8 January

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