Norwegian Currency Suffers Illiquidity

EURNOK

Bearish forex strategies on the NOK are more visible than ever. Barclays forex analysts lowered their forecasts for the NOK. They expect the EUR/NOK at 8.20 six months from now. The broker expects volatility to hover around this level to be constantly lifted. Headwinds remain in the near term and Barclays forex strategies dictate an appreciation over the medium term. The twelve month forecast is 7.70.

Liquidity Risks

The volatility in EUR/NOK was largely driven by a fast erosion in liquidity conditions which hasten the impact of unwinding. Generally, legacy long positions on the NOK and high ownership of foreign debt pose liquidity risks that pressure the NOK. Despite that the forex strategy of Barclays reported that a further reduction in FX market liquidity is still the main near term risk. Risk reversals in the NOK are currently pricing enormous bearish NOK sentiment on a cross-sectional basis but not on a historical basis. The analysis of this goes like if liquidity will further diminish, volatile price action and fundamental misvaluation would continue.

Liquidity has historically been poor for the NOK. It is considered the second-most sensitive currency to economic shocks to liquidity out of the G10 currencies, as proxied by the beta to our G10 liquidity index. This liquidity issue has worsened lately though. Bid-offer spreads in EURNOK (a general proxy for market liquidity) have fattened and EURNOK vol has also decoupled from the vol of other risky currencies such as SEK and AUD. Take this case, 3m ATM EURNOK vol is two standard deviations above its two-year average, suggesting liquidity concerns are being felt disproportionately in the NOK. Previous periods of market stress such
as 2010 and 2011 have not seen implied vols decouple.

Barclays is not certain though why these liquidity risks have resumed. The attractiveness of the NOK which has become the most liked among safe haven seeking investors in 2012 has constantly declined against its peers. They also noted that a further reduction in the demand for ‘other’ currencies (which likely includes NOK) as the diversification away from the USD gradually slows.

Liquidity squeezes tend to become self-fulfilling, so while they prefer owning the currency on a medium-term horizon, they expect this volatility to stay over the near term, with few reasons to expect a sudden improvement in liquidity conditions. The blunt liquidity squeeze have been skewed to the upside in EUR/NOK, provided that the NOK positions are unwound. Hence, options market prices have a strong positive correlation between EUR/NOK spot and EUR/NOK volatility which signals that moves to the upside will be volatile.

Norges Bank’s FX transactions data show continuous selling of EUR/NOK by foreign banks since early 2010 up until the start of 2013. Since then, the flows have reversed but, relative to the size of the NOK inflows in the preceding years, this correction has been minor.

EUR/NOK

There are fundamental factor that drive the NOK lower in the last months. The NOK spot rate was estimated by Barclays to be two standard deviations apart from implied fair value. The gap in pace of EUR/NOK showed only a small part of the currency movement while both short term and long term interest rates have moved against the NOK and in favour of the EUR. Additionally, higher oil prices and global equities have put downward pressure on the forex pair.

Short term interest rates like the Nibor have fallen lower, leading to a lower money market premium, despite that the Norges Bank is keeping a flat base rate for 18 months. This can be further explained by the forex strategies of Norges Bank being dovish bias where macro-prudential measures were taken to alleviate financial imbalances.

The counter-cyclical buffer (CCB) which will be implemented into regulation has already resulted in higher lending rates in Norway, specially in the mortgage space.

Domestic banks have pre-empted the CCB requirements to hold more common equity by hiking lending rates. This has increased their margins and reduced the funding rates over the base rate in relations to a stable base rate and falling financing costs. Lower reliance on wholesale funding markets (proxied by the wholesale funding ratio) has also added pressure to the money market premium.

Premium Risk

The declining money market premium can be perceived as a pullback to NOK. Forex strategies need to be revisited as Barclays is expecting that this money market premium to bloat like what happened in 2010 and 2011. There are no forex signals however, that the US dollar funding pressures beyond some volatility in the front end caused by ongoing US fiscal negotiations.

The forex strategies of analysts are generally constructive on the monetary policy of Norway. They expect the Norges Bank to become the first major bank to start tightening policy next year. A drop in deflationary pressures was seen driven by weakness in the currency. Although the Norges Bank has emphasised the temporary nature of the upticks in July and August.

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