Norges Bank preview A 25bp rate cut and easing bias

Investment Research 17 March 2015 Norges Bank preview A 25bp rate cut and easing bias We expect Norges Bank (NB) to deliver a 25bp rate cut on Thursday. NB is set to keep the easing bias by presenting a new rate path with a 50% implied probability of another rate cut before June. However, we do not expect Norges Bank to cut rates further post March. Even though key figures have been mixed, the central bank has a history of preferring the Regional Survey as a guidance. This implies a downward adjustment of GDP growth in 2015. The wage growth ended up weaker than expected in 2014 and signals from the labour market organisations point to a moderate wage settlement this year. Global rates have dropped since the December report, adding downward pressure to the interest rate path. The primary risk to our projection is that of NB leaving the rate unchanged. First, NB could put less emphasis on the Regional survey and more on other key figures. For instance, the import-weighted NOK is roughly 3.5% weaker than assumed in the December report. This will partly counteract the downward adjustment of the interest rate path, and also reduce the possibility of a rate cut. Second, the increasing pressure in the housing market in the aftermath of the December cut could keep NB on hold until the recession is confirmed. FX Strategy: we expect EUR/NOK to bounce around the NB meeting before a trend lower in the cross constitutes. Leverage funds should look to sell EUR/NOK post the NB meeting. Corporates should hedge NOK income via option structures that maintain a profit potential. Fixed Income Strategy: all in all, we see downside to NOK money market rates after the announcement, but we think from a risk reward perspective that more value is found in the long end of the NOK yield curve. We recommend to buy 10Y NGBs against bunds or alternatively to receive NOK swap 5y5y against EUR, especially for those not interested in the FX exposure. We expect a downward adjustment of the rate path signalling a 50% probability of another rate cut. Source: Norges Bank, Danske Bank Markets Market pricing of NB is already too dovish long-term 1.40% 1.25% 1.20% -19 1.00% 0.80% 0.60% 0.40% 0.20% -48 Norges Bank Pricing* -59-60 -62-60 0.00% Mar15 Jun15 Sep15 Dec15 Mar16 Jun16 *Approx. from stripped FRAs Source: Bloomberg, Danske Bank Markets Chief Economist, Norway Frank Jullum +47 85 40 65 40 fju@danskebank.com Chief analyst, Head of Fixed Income Research Arne Lohmann Rasmussen +45 45 12 85 32 arr@danskebank.dk Analyst Kristoffer Lomholt +45 45 12 85 29 klom@danskebank.dk Important disclosures and certifications are contained from page 7 of this report. www.danskeresearch.com

NB to deliver In the December Monetary Policy report, Norges Bank (NB) signalled a 50% probability of another rate cut before June. We expect NB to deliver a rate cut on Thursday and present a new rate path signalling a 50% probability of another rate cut before June 2015. We do, however, not expect more rate cuts post March. Downward adjustment of the rate path Reasoning Since the December meeting, the key economic indicators have been rather mixed. There is no doubt that growth is abating, but there are no indications of a severe downturn. The drop in oil prices has resulted in a sharp drop in activity in the oil related sectors. However, this is counteracted by a lift in export industries on the back of a weaker NOK and stronger global growth. In addition, lower interest rates are lending support to both private consumption and housing demand. The latter is gradually improving residential construction. Finally, as fiscal policy is completely sheltered from the drop in oil prices due to the Petroleum Fund mechanism, fiscal expansion carries on as well. As a result, the labour market is holding up pretty well and the rise in unemployment has been moderate. The overall unemployment is lower than a year ago. Source: Norges Bank, Danske Bank Markets Regional survey points towards slower growth The exchange rate is weaker than assumed Source: Macrobond, Danske Bank Markets Source: Macrobond, Danske Bank Markets However, the Regional Survey from Norges Bank painted a more pessimistic picture of the economy than hard data have indicated. The aggregated output index dropped to 0.39, signalling a GDP growth around 0.2 % q/q in the next two quarters. Surprisingly, the survey indicates a worsening outlook for both the export industry, the construction sector and the retail sector in addition to the expected downturn in oil-related industries. While it is noteworthy that the survey has underestimated GDP-growth since mid-2013, the survey remains Norges Bank s preferred economic indicator. Hence, we expect Norges Bank to use the Regional survey as a basis for a downward adjustment of the GDP-forecast for 2015, from 1.5% to 1.25%. The actual inflation has been roughly as expected and will hardly affect the rate decision nor the interest rate path. However, the overall wage growth in 2014 ended up weaker than forecasted at 3.1%. At the same time, the signals from the labour market organisations point to moderation in the central wage negotiations next month. We also expect the local negotiations, and the general wage drift, to be moderate as the unemployment rate is rising and corporate profits are taking a hit. As known, other central banks have moved to negative rates. This will of course affect the rate setting and the interest rate path at Norges Bank. A closer look at the developments since the December meeting tells us that the (weighted) average of global forward rates has dropped by approximately 15bp for Q4 15 and 25bp for Q3 16. 2 17 March 2015 www.danskeresearch.com

Finally, the exchange rate is a lot weaker than NB assumed in December. At the time of writing, the import-weighted NOK is 3.5% weaker than NB assumed as an average for Q1. So far in Q1, the NOK has been 2.9 % weaker than this assumption. Since the publication of the December MPR, the oil price has dropped from USD70 to USD45 per barrel, but has recently stabilised at around USD55. This, of course, adds downside risk to the economy and hence the inflation outlook and interest rates. However, the February oil investment survey confirms that oil investments should drop around 15% in 2015, which is in line with the forecast in the December MPR. Therefore, we expect the oil price and the oil investments to play a less important role for the rate decision and the rate path than the market currently seems to believe. Interest rate path to be adjusted downwards: Danske Bank expectation for new rate path based on contributions (bp) Contributions (bp) New rate path Growth Inflation/costs Global rates FX Total (%) 2015Q2-15 -10-5 20-10 1.03 2015Q3-20 -15-5 25-15 0.98 2015Q4-25 -20-5 30-20 0.93 2016Q1-25 -25-10 30-30 0.83 2016Q2-25 -25-10 35-25 0.88 2016Q3-25 -25-10 35-25 0.92 2016Q4-20 -25-10 30-25 0.99 2017Q1-20 -20-5 20-25 1.07 2017Q2-15 -20-5 15-25 1.17 2017Q3-10 -15-5 10-20 1.33 2017Q4-10 -15-5 10-20 1.44 Expected market reaction We expect Thursday s decision to weigh on rates across the curve. In the short end, a full 25bp rate cut has not been fully priced (currently interest derivatives markets price in roughly 19bp). In the longer end, we expect markets to price in further rate cuts, which should weigh on what we consider - to be an already stretched long run pricing of more than two rate cuts. Primary risks to our projection There is a risk that NB will keep rates unchanged. First, NB could include a broader set of key indicators besides the regional survey in its assessment of the economic stance. As we argued in the previous section, the key indicators have painted a less pessimistic picture of the cyclical position than indicated by the Regional survey. In particular, there are clear signs of a significant improvement in the export industries on the back of stronger global growth and a weaker NOK. Housing starts have started to pick up as well and the acceleration in housing prices should be an indication of a further increase in residential investments. All in all, the outlook is clearly weakening, but the question is whether this really is weaker than expected. Second, the increasing pressure in the housing market after the December rate cut could keep NB from cutting rates further until the downturn in the economy is confirmed. Housing prices have accelerated, inventory-to-sales has dropped to 1.8 months and the average time to sell is down 12.5% y/y. Keep in mind that the elevated level of household debt and real housing prices in Norway is de facto reducing monetary policy flexibility. Of course, we are aware of the fact that the Ministry of Finance has asked the Financial Supervisory Authorities to deliver an overview of measures that could be implemented to restrain the growth in housing prices by 19 March. Long run market expectations seem stretched already 1.40% 1.25% 1.20% -19 1.00% 0.80% 0.60% 0.40% 0.20% -48-59 -60-62 -60 0.00% Mar15 Jun15 Sep15 Dec15 Mar16 Jun16 *Approx. from stripped FRAs Norges Bank Pricing* Source: Bloomberg, Danske Bank Markets 3 17 March 2015 www.danskeresearch.com

FX outlook Short term (0-3 months): to peak around March NB decision and then lower We have long argued that the NOK from a fundamental perspective is cheap, which is also reflected in our longer-term forecasts. Our expectations of a gradual oil price recovery this year and our view that the Norwegian economy will hold up relatively well against the oil price collapse is supporting this fundamental view in 2015. EUR/NOK to move higher short term and lower in the long term 9.75 9.50 9.25 9.00 8.75 8.50 8.25 8.00 EUR/NOK 7.75 Mar-14 Jun-14 Oct-14 Jan-15 Apr-15 Jul-15 Nov-15 Feb-16 Market pricing of Norges Bank is too hawkish short-term, too dovish longterm 1.40% 1.25% 1.20% -19 1.00% 0.80% 0.60% 0.40% 0.20% -48-59 -60-62 -60 0.00% Mar15 Jun15 Sep15 Dec15 Mar16 Jun16 *Approx. from stripped FRAs Norges Bank Pricing* 75% conf. int. 50% conf.int. Forward Danske fcst Consensus fcst k EUR/NOK 1M 3M 6M 12M Forecast (pct'ile) 8.75 (56%) 8.50 (28%) 8.25 (16%) 8.15 (18%) Fwd. / Consensus 8.74 / 8.74 8.76 / 8.71 8.78 / 8.58 8.82 / 8.42 50% confidence int. 8.54 / 8.90 8.47 / 8.98 8.39 / 9.06 8.28 / 9.19 75% confidence int. 8.43 / 9.06 8.31 / 9.22 8.18 / 9.39 7.98 / 9.64 Source: Bloomberg, Danske Bank Markets As we expect Norges Bank to cut rates by 25bp on Thursday and as it has not yet been fully priced in the interest rate derivatives market - market pricing currently suggests roughly a 75% probability of our call materialising - Thursday s meeting should send EUR/NOK higher. This is also supported by our expectation that markets will price in more rate cuts on Thursday post the dovish surprise. In order to estimate exactly how much higher EUR/NOK should go on the back of a rate cut and an expected dovish stance from NB, we turn to our FX short-term financial models. Assuming an unchanged oil price, we expect a 25bp rate cut and Norges Bank signalling a 50% probability of another rate cut to send the EUR/NOK fair value estimate towards 8.85, everything else equal, thereby temporarily overshooting our 1M target of 8.75. Importantly, however, EUR/NOK may also temporarily overshoot this fair value estimate after the announcement. Indeed although EUR/NOK spot currently trades within the +/- 2 standard deviation band in statistical terms, the spot level already trades 2 figures above the short-term fair value estimate. We expect EUR/NOK to peak after the March meeting around our 1M target of 8.75 and that the cross will subsequently trend lower on a 3M horizon towards 8.50. Short-term model indicates that EUR/NOK trades close to fair value Rates and oil price have been important drivers 2.0% PPP model estimate suggests that EUR/NOK remain overvalued 1.0% 0.0% -1.0% -2.0% W-8 W-9 W-10 W-11 2Y swap spread 10Y swap spread Vix Oil European sovereign spread Source: Bloomberg, Danske Bank Markets Source: Bloomberg, Danske Bank Markets Source: Bloomberg, Danske Bank Markets 4 17 March 2015 www.danskeresearch.com

Medium term (+3 months): NOK appreciation trend Medium term, the gradual oil price recovery, the end of Norges Bank easing together with ECB QE playing out will be supportive factors for the NOK vis-a-vis the EUR. We expect that Brent Crude will rise throughout the year towards USD76/bbl in Q4 and that the Norwegian-Euro zone policy rate spread will remain at around 1%. We target EUR/NOK at 8.25 in 6M and 8.15 in 1M. The main risk factor for our medium and long-term bullish NOK forecast is that the lagged effect of the drop in oil investments turns out to have a more severe effect on the economy than expected (i.e. labour market, private consumption and the housing market are hit harder). This could trigger more rate cuts from Norges Bank than we currently anticipate. FX Strategy Leverage funds We currently do not have any live trade recommendation in the NOK in our FX Trading Portfolio and recommend leverage funds to stand sidelined ahead of the NB meeting. Fundamentally, we regard NOK as cheap and will look for opportunities to buy the NOK post the NB meeting. If we are right in our call on Norges Bank, we will look to short EUR/NOK on the immediate mover higher post the NB meeting. It could also be considered to position for a move higher in NOK/SEK as the cross looks fundamentally cheap, as the SEK looks technically oversold and as the Riksbank likely will react to a further SEK strengthening by easing monetary policy further. Note that long NOK/SEK is one of our ten Top trades of the year (see FX Top Trades 2015, 3 December). Real Money Funds As we regard the move higher in EUR/NOK to be only temporary, we recommend EURbased real money funds to maintain a high hedge ratio for short-term NOK exposures but to gradually lower the hedge ratio for medium- to long-term NOK exposures. Corporates We recommend to hedge short-term NOK expenses via option structures that maintain a profit potential in case of a weaker NOK. Specifically, we recommend to utilise the attractive option skew via short-term risk reversals. Medium to long-term expenses should be locked-in via FX forwards, thereby benefitting from the interest rate differential between EUR and NOK. EUR/NOK fair value estimate to drop to 8.20 by end 2015 on oil price recovery alone Source: Macrobond, Danske Bank Markets While we recommend to protect short-term NOK income via FX forwards, we still recommend corporates to hedge medium- to long-term NOK income via option structures that maintains a profit potential in case of a stronger NOK. As implied volatility currently looks cheap, we specifically recommend participating forwards where a worse case rate is guaranteed while still maintaining a 50% profit potential in case of a stronger NOK. Implied volatility looks cheap Risk reversal looks expensive Carry in neutral territory 17 Implied volatility (EUR/NOK) realised volatility 16 15 14 13 12 11 10 9 8 7 6 5 Mar-14 Jun-14 Sep-14 Dec-14 Price indicator: implied volatility cheap neutral expensive 3.50 3.00 2.50 2.00 1.50 1.00 0.50 EUR/NOK risk reversal 0.00 Mar-14 Jun-14 Sep-14 Dec-14 Price indicator: risk reversal (NOK seller) cheap neutral expensive 1.10% Mar-14 Jun-14 Sep-14 Dec-14 Mar- Price indicator: forward rate (NOK seller) cheap neutral expensive Source: Bloomberg, Danske Bank Markets Source: Bloomberg, Danske Bank Markets Source: Bloomberg, Danske Bank Markets 1.80% 1.70% 1.60% 1.50% 1.40% 1.30% 1.20% 3M forward (%, ann.) 5 17 March 2015 www.danskeresearch.com

Fixed Income strategy Value in NGBs and attractive to receive NOK 5y5y swap vs EUR Even though our Norges Bank view is probably close to current market and consensus expectations, the confirmation that Norges Bank is still on an easing bias should push market rates a bit lower as the market will probably start to price in a somewhat higher probability of two more rate cuts this year on top of the one on Thursday. Currently, the market expects according to the FRA-curve that 3M NIBOR will drop to around 0.90%. If we assume a 20bp spread between 3M NIBOR and the policy rate, it implies that the market expects Norges Bank to lower rates to around 0.70%. Given the renewed downward pressure on oil and our view on the Norges Bank, we expect some downside to NOK money market rates this week. NOK rates have moved higher over the last two months Pricing NOK-OIS 1m swap 1.30% 1.10% 0.90% 0.70% 0.50% 0.30% Jan15 Jul15 Jan16 Jul16 Jan17 Jul17 Jan18 Jul18 Current live 26-Jan-15 However, we believe that from a risk-reward perspective more value is found in the 10y segment and in the latest issue of Scandi markets ahead we took a closer look at this part of the curve. NGBs have lost against bunds 5y5y has widened against EUR and is attractive to receive 4.5 SWAP 5y5y NOK 6M (l.h.)) SWAP 5y5y NOKvs EUR (r.h) 1.5 1.45 4 1.4 1.35 3.5 1.3 1.25 3 1.2 1.15 2.5 1.1 1.05 2 1 We argue that the 10Y NGBs are attractive as Norway has underperformed significantly against bunds since mid-february and as NGBs offer a positive yield around 1.5%, which is well above countries such as Spain, Italy and not least Germany. We also argue that NGBs have a positive supply outlook and a positive net cash flow in Q2 for NGBs, when the NGB May 15 expires. Finally, we of course refer to the monetary policy outlook and the possibility of the market pricing in a higher probability of more rate cuts. The currency risk of buying NGBs against bunds is of course evident. Hence, for those not interested in the FX exposure one could also consider receiving NOK swap 5y5y against EUR, which trades around 137bp. 6 17 March 2015 www.danskeresearch.com

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