Market Economics | Interest Rate Strategy - BNP PARIBAS ...

At first glance, this latest development is puzzling. A
current account surplus and changes in capital flows
mean Denmark is still running a basic balance
surplus, pointing to a stronger currency. Also, there is
still a 25bp gap between the interest rate on
certificates of deposit in Denmark and the ECB
deposit rate – hence arbitrage opportunities continue.
Chart 3: Use of Deposit Facility at the ECB &
EUR/DKK
So what is driving the recent depreciation of the DKK
vis-a-vis the EUR?
…driven by developments in the eurozone policy
There seems to be a relationship between the use of
the deposit facility at the ECB and developments in
EUR/DKK over the past couple of months (Chart 3).
The depreciation of the DKK could be partially driven
by lower excess reserves in the eurozone, which
could suggest lower flows into the DKK.
Since the end of June, short-term money market
rates in the euro area have also been drifting higher.
The 1-week and 3-month Euribor rates have risen
10-15bp over the past three weeks and are now back
at their levels of June and August last year,
respectively. The recent changes to refinancing
operations at the ECB, including the expiry of the first
1-year long-term refinancing operation, have reduced
the excess liquidity in the system. This is pushing
money market rates higher. Also, at the press
conference after the rate decision last week, the ECB
hinted at backing away from its unconventional
measures. We believe the ECB should commit to
take whatever action is necessary, given the
problems in the eurozone sovereign debt markets
and banks. But the ECB seems to be pushing on with
the exit strategy, leading to expectations of higher
rates (although the ECB has asserted that the
increase in short-term rates should not be interpreted
as a policy signal).
In the meantime, Danish money market rates have
been hovering around their all-time lows. With EUR
rates now pushing up, money market spreads are
trending lower. For example, given lower excess
liquidity now in the eurozone, the Danish overnight
rate spread vis-à-vis the eurozone has even turned
negative (Chart 4). This is leading to outflows from
the DKK into the EUR.
The implications for Danish monetary policy
We had expected the Danish central bank to cut its
policy and deposit rates further as rate differentials
with the eurozone were leading to an appreciation of
the krone. But the recent depreciation of the DKK visà-vis
the EUR suggests rate cuts are now unlikely,
leading us to change our view.
There is already some evidence that the central bank
Source: Reuters EcoWin Pro
Chart 4: O/N Rate Spread (%) & EUR/DKK (% y/y)
Source: Reuters EcoWin Pro
Chart 5: Foreign Exchange Reserves
Source: Reuters EcoWin Pro
started to draw on its FX reserves to defend the
currency (EURDKK ticked down on 14 July and
pushing lower at the time of writing).
Our assumption is that the ECB will further extend its
liquidity provision, although likely divisions on the
Governing Council could delay the implementation of
such policies. Given this, the Danish central bank is
likely to continue to draw on its FX reserves in the
short term to support the currency. Only if such
action fails, and reserves fall too much, the bank will
need to hike rates.
Gizem Kara 16 July 2010
Market Mover
13
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