Forex Investment and Currency Trading

• SEK and NOK are the star performers of 2008, but recommend staying short EUR/SEK and EUR/NOK.
• Despite as expected Riksbank and Norges Bank outcomes this week, the risk is of significantly more tightening.
• In contrast, this week’s unexpected fall in the German Ifo may well mark the watershed in ECB rates.

SEK and NOK the star performers of 2008
This week, Norges Bank delivered a 25bp hike taking rates to a five year high of 5.5%, while the Riksbank left rates at 4.25%. Both decisions were in line with expectations, but SEK and NOK are still first and second best performing G10 currencies over the last three months respectively. Should we look to take profits in SEK and NOK and is the risk growing that the rate driver of NOK and SEK out-performance starts to fade?

Bullish case for SEK and NOK against EUR is based on the relative progress the respective central banks have made in the “normalisation” of rates. The ECB is widely seen as having been stopped in its tracks by the onset of the global credit crunch last summer. A more neutral global environment would have allowed the ECB to continue with the process of one 25bp hike per quarter that ended with the last hike in June. However, objective measures of policy neutrality suggest the ECB was probably only one or two hikes short of reaching neutral rates anyway. Current Taylor rule neutral rates, for example, stand at 4.5%, based on current Eurozone inflation (3.6%) and the OECD’s output gap estimate for 2008 (-0.3%).

Even on extreme assumptions about the growing insensitivity of economies to exchange rate movements  the 10.6% appreciation in the EUR effective index since the ECB’s last hike must surely have delivered at least as much tightening as an ECB with a free hand would have delivered. Indeed, we would argue that the
unexpected drop in the March German Ifo survey may well mark a watershed in ECB rate expectations, despite the apparently hawkish comments from Governing Council members Mersch and Noyer earlier this week.
Norway and Sweden - far from neutral
How does policy in Norway and Sweden compare? In Norway in particular, even after the four 25bp hikes Norges Bank has delivered since last summer, policy is nowhere near a neutral setting. Based on consensus CPI forecasts and again on the OECD’s output gap estimates (which are close to Norges Bank’s own), neutral rates in Norway are as high 7.0% currently and are set to rise to close to 8% by end-2008 as ongoing strong growth drives output further above potential (again based on the OECD’s estimates). Norges Bank’s own
guidance allows for the possibility of one more rate hike in the current cycle and this is reflected in the current forward curve. But the balance of risks is that this is revised significantly higher as the year progresses.

Stay short EUR/NOK and EUR/SEK
Current rates in Sweden are still below Taylor rule neutral, though less significantly so (around 75bp) than in Norway. The Riksbank’s current guidance on rates suggests no change in the repo rate for the entire forecast horizon to 2011, but as February’s out of the blue hike showed, the central bank’s view is prone to change with the dataflow. In the absence of a significant deceleration in activity or decline in core inflation (2.3% y/y in March), the bias must remain to the Riksbank guiding rate expectations higher rather than lower, in contrast to the easing bias priced into SEK FRAs.
Relative to forward curves in particular, interest rate dynamics suggest remaining positive on both SEK and
NOK. Moreover, in contrast to the 10% EUR trade weighted appreciation since last summer, trade weighted
SEK is up only 2.5% and trade weighted NOK up only 3.7% and the policy tightening through the exchange rate has therefore so far been minimal in both cases