More on the Future Prospects of the Norwegian Krone (It’s still on the way up)

Back in January my dear co-author Jørund wrote a short piece on  the future prospects of the Norwegian krone, whereby Evolution-Revolution agreed with Credit Suisse’s prediction that the krone was on its way up (while, admittedly, making ourselves guilty of blogger-journalism-commentator hedging dicussed in this post by the eminent Baruch at Ultimi Barbarorum). Since then, the Norwegian Krone has, indeed, strengthened a bit vis-a-vis both Euro, Pound, and Dollar (although as Nassim Taleb would be quick to point out, this might have been completely random). Nevertheless, the krone still has a way up to go, even more so than it did in January.

In particular, three factors underlie this prognosis:

1) Norway’s economic performance has been even better than expected in January, and the structural deficit covered by transfers from the Government Pension Fund (GPF, the $300 billion “Oil Fund”) is now smaller than predicted. Interest rates will probably rise faster than previously expected.

Last year, many domestic commentators were afraid that “temporary” spending increases from after the crisis that appeared to become more permanent in the 2009 budget would leave the government spending money from the Government Pension Fund  above the “budgetary rule” for several years. This “budgetary rule”, a guideline for policymakers, states that in order to ensure macroeconomic stability and long-term fiscal sustainability, no more than 4% of the value of the fund (the estimated average yearly return) should be spend in each year’s budget. The consensus is that more can be spent during recessions, and that this will be covered during periods of higher growth – basic Keynesianism, except the Government is “borrowing” from it’s own piggy-bank to finance expansionary fiscal policy. Numbers from the national accounts presented last week, however, show that the government spent around 15% less money from the Government Pension fund than previously expected. Norway’s already rock-solid public finances are even more rock-solid than previously expected.

Unless this windfall is turned into more spending in next year’s budget, or GDP shrinks unexpectedly, Norway will be back to the 4% budgetary rule in 2013. Regardless of whether spending is increased, though, less pressure on Government to cut spending will ease the need to keep interest rates low.

Above: Realised and expected values for the key policy rate, from the latest Monetary Policy Report published by Norges Bank (Norway’s Central Bank), expect them to be adjusted upwards, perhaps as early as tomorrow (source).

There is still worrying, though, that increasing spreads between Norwegian and foreign interest rates will cause the Krone to rise so much as to harm a Norwegian export industry already troubled by falling international demand. According to Central Bank Chief Svein Gjerdrem, “There is much to suggest a higher interest rate now. What makes us hold back, is that the interest rate is even lower in other countries. If we are too radical, the krone might strengthen too much.” Nevertheless, the Chief of the Central bank worrying that rate hikes he thinks are necessary might strengthen the Krone too much is hardly a bearish sign. Even if Norges Bank does not raise interest rates more than the expected 0,25 percentage points after the meeting tomorrow, interest rates will have to go up in the near future.

2) The Eurozone is even weaker now than it was in January. Even if the massive Greek bailout saves the country from financial collapse, it has left the Eurozone less able to deal with troubles in Spain or Portugal, should they worsen.

So much is written on this that I won’t spend a lot of space on it here. At any rate, even if everything blows over eventually, it won’t do so for a while, and it is unlikely that financial markets will stop worrying in the near future. In the meantime, the need for a “safe haven” currency is likely to increase as contagion worries proliferate and the Euro weakens as more debt is taken on to keep the southerners afloat.

3) Britain might have a hung parliament on Friday, making spending cuts and handling the deficit more difficult.

Some of this risk was arguably priced in as early as Nick Clegg’s spectacular debate performance on April 16th. Nevertheless, in the event of a hung parliament, worrying over the pound is likely to continue and worsen as the political battles in the parliament unfold over the next months and years. The need for a “safe haven” currency vis-a-vis the pound is likely to increase, and the pound is likely to weaken further amid increasing debt worries.

One risk factor, though, is the high correlation of the Norwegian Krone with the oil price, which could mean a dramatic dip in the price of the currency if the price of oil does so. On the other hand, this also makes it possible to hedge a long krone position with short oil exposure. Depending on how expensive such a hedge would be, hedged carry trades could be possible.