Economy 29 October 2013, 12:27pm

Hungary awaits 15th rate cut ahead of Tuesday policy meeting

Portfolio

The rate-setting Monetary Council of the National Bank of Hungary may approve another 20 bp rate cut at Tuesday afternoon's meeting. Weak inflationary pressures, slack economic performance and a supportive global market sentiment are all pointing in the same direction. Meanwhile, it is becoming cheaper and cheaper to short the Hungarian forint, a threat that making the EUR/HUF exchange rate increasingly more vulnerable.

The Monetary Council may approve the 15th rate cut in the current easing cycle on Tuesday. To date this has been the longest rate cut cycle in the history of Hungary's central bank. Should analyst expectations be proven right, the interest rate on the key two-week instrument will go down to 3.4%.

This could be the third successive rate cut when monetary policymakers lower the rate by 20 bp, deviating from its earlier practice of 25 bp moves. The change does not make any sense whatsoever, but in August (when confidence in the rate cut cycle was slightly shaken) the new format was seen as a convenient tool of further easing. However, the decline in global market sentiment that was taking place at that time proved to be a fleeting trend, clearing the way for further rate cuts to proceed in Hungary.

Once again, it is a positive investor sentiment that has created room for monetary maneouvre in Hungary, as the Fed is seen delaying a taper of asset purchase programme. This is having a positive impact on capital markets, especially on the more vulnerable emerging markets. The risk premium derived from forint-based government bond yields remains supportive, while Hungary's CDS is also on the decline, coupled with forint firming in recent weeks.

However, a spectacularly low base rate does come with a price tag as it poses a threat to financial stability. Long-term yields seem reluctant to drop as fast as short-term yields do, something that could be indicative of markets suspecting a potential interest rate overshoot. (According to the latest market surveys, the base rate could rise back to 3.8% by the end of 2014 - that is, taking today's rate cut for granted, analysts have priced in at least two monetary tightening moves next year.) In its latest rating update last Friday, S&P warned that the possibility of a major capital flight from the Hungarian bond market is still lingering on.

It is also worth noting that as a result of rate cuts, the 3-month implied forint interest rate (i.e. the carry that is so important to currency margin traders) is now hovering near a historic low. That is, it is becoming increasingly cheap to short the forint, something that is most certainly causing the currency to become more vulnerable. There could be an increasing cost in credibility to cutting the interest rate so low. As long as a potential deterioration in global market sentiment has roughly the same impact on monetary policy across emerging economies, it will not necessarily bring such issues about. However if it triggers much greater fluctuation in forint exchange rates than in other currencies, the NBH would be forced to carry out a major rate hike, something that could prompt investors to see monetary policy as less than successful.

For the moment being, however, no-one is expecting such a scenario, given the fact that US macro data have failed to impress, and incoming Fed chief Janet Yellen is even more sensitive to the economic impact of monetary policy than her predecessor. This means that the NBH, operating in a system of inflation targeting, will see no deterrent to another rate cut in light of Hungary's latest inflation report. Although September saw the CPI jump to 1.4% as opposed to the expected 1.1%, this is still a very low figure, especially as the jump is due to such one-off factors such as a dramatic increase in banking fees (as a result of transaction tax), higher retail tobacco prices (as a result of a major overhaul restricting sale to state-licensed vendors) and rising taxi fares (as a result of new taxi regulations in Budapest).

However, it should be noted that some subtle shifts are apparent in long-term price trends as well. Price hikes are not only due to a direct increase in state-regulated prices; consumer prices could be also rising as an indirect result of government measures such as higher taxes on companies that the latter pass on to clients, the impact of a weak forint, plus the fact that rising real wages create room for these factors to exert an impact. On the other hand, as Portfolio.hu noted in a comment on the September inflation report, Hungary's interest rate policy seems to be unfazed by inflation for the moment being, at best the word 'prudence' will feature heavily in Monetary Council communication while rate-setters approve further rate cuts. Should inflationary trends follow the current path, however, it could become an issue that the national economy is after all not quite so much behind its potential maximum output, in which case further rate cuts may result in a credibility gap.

For the moment being, however, the central bank is not facing any such issues; the handful of data available at this point is insufficient to determine whether it is really a case of an inflationary trend change. While waiting for additional inflation reports to stake out see a trendline, the NBH still has enough time available for several rate cuts before the end of the year if that is what it wants to do.