This is why Hungary's forint is in pain

This is nothing we have ever seen

As the central bank clarified what unconventional monetary policy measures it has up its sleeve, the market has relaxed and that reignited the decline in government security yields. Needless to say, the improvement in global risk appetite and the liquidity boosting impact of a recent announcement by the Bank of Japan also helped. These factors allowed the Monetary Council to lower the key policy rate to an all-time low of 4.75% this month. In parallel with this the yields on forint bonds dipped to their lowest level in the past 15 years.

The chart below clearly shows that the whole segment of the HUF yield curve has dropped compared to a month ago, but due to rate cut expectations the decline was more pronounced at shorter maturities.

While Hungary’s inflation decelerated to its lowest level in 37 years the MPC reduced the benchmark policy rate by a total of 225 basis points over the past nine months (starting in August 2012) and the market still thinks this is not the end of the line. As the chart below indicates the market is currently pricing 65bp cuts for the next three months and almost 100bp for the next six months, i.e. the base rate is expected to go below 4.00% by the autumn.

We need to note that HUF yields dropped so sharply that on several maturities and foreign currencies they caught up with the yields of FX bond yields (that are generally at lower levels since they do not have to compensate for the risk stemming from unfavourable exchange rate shifts).

The chart below clearly depicts that the yield curve of EUR-denominated government bonds is almost “fused" with that of HUF bonds, especially in the 5-7-year segment.

Hungarian premium gone

This means that the yield premium offered by Hungarian forint bonds has practically vanished, as the chart below also attests. The yield on the 5-yr benchmark bond may be split into a risk-free part (German 5-yr Eurobond) and a part that constitutes Hungary’s country risk (premium of Hungary’s 5-yr Eurobond over the German Bund). Extracting these two factors from the yield of Hungary’s 5-yr bond we’ll get the risk premium offered by this forint asset. This is indicated by the grey area, which has melted to virtually zero over the past few weeks.

A close-to-zero risk premium was recorded twice over the past two years. Once when the NBH was forced to hike rates in a similar situation at the end of 2011 and then again around May-June 2012, when the central bank was not let lower its key policy rate by the vanished risk premium or more precisely the inflationary-financial stability framework system).

The periods marked by the red rectangles show that when the risk premium on HUF bonds dropped close to zero the forint generally stepped on a weakening path. Therefore we should not be surprised about HUF easing now. At this point the outlook on inflation obviously provide room for more rate cuts, but the forint’s depreciation triggered by the disappearance of the HUF risk premium increases financial stability risks via the high stock of foreign currency debt.

Where do we go from here?

In view of past experience the current state (vanished risk premium on HUF assets) cannot be sustained for long (due to exchange rate risks there must be at least some premium). The big question is how this situation may be resolved. We see two possible ways.

(1) The market realises that yields on Hungarian HUF government securities are at overly low levels (i.e. they no longer reflect the risks) and through profit taking mostly longer yields move slightly higher. This scenario may be triggered if in response to the forint weakening the NBH indicates itself that monetary easing will be tamed and the base rate will be lowered by less than what the market is pricing, i.e. 25 bps a month). As a result yields on longer instruments will once again offer a premium. The same result could be achieved if global factors for instance led to a further drop in the yield on Hungary’s foreign-currency bonds.

We have no way of knowing, of course, which of the above two scenarios will materialise, but we do know that the NBH would probably need the second one to be able to proceed with its current rate cut cycle.

• Tags:
• MNB,
• exchange rate,
• prémium,
• central bank,
• bond,
• yield,
• huf,
• foreign currency,
• eurobond,
• forint