It has occurred for the first time in many years that the market is testing the commitment of the National Bank of Hungary (NBH) to its loose monetary policy stance, and the weakening of the forint has already forced the central bank to formulate its words more carefully after its monthly policy meeting, Morgan Stanley said in a recent research note. In a Q&A, MS offers its latest understanding of the challenges that the NBH faces as it adjusts its policy to the new reality. They think that the market is likely overestimating the chance of higher rates ahead.
A better inflation backdrop and a benign external environment, together with vastly improved fundamentals, have allowed the NBH to cut rates aggressively to support growth. A more challenging external backdrop and the return of inflation to the target, together with tighter policy elsewhere, creates a more challenging backdrop for the NBH. Over the last few weeks, risk aversion strengthened on emerging markets as inflation started to accelerated, the key central banks around the world stepped on a tightening path. The NBH is still holding its ground therefore the forint eased to 330 to the euro and rebound only from there to 322.
Morgan Stanley has taken stock of the main questions investors have been asking in recent weeks, reflects on the findings of several visits to Budapest over the years, and offers its understanding of how the NBH will likely navigate these more turbulent waters.
Analysts at the U.S. bank think that the NBH's tolerance for FX weakness is higher than many assume. Also, while the bank's change in tone at the June meeting was crystal-clear, they would envisage a more dovish rate path than what the market is currently pricing in.
1. How does the NBH think about the inflation target?
The NBH targets inflation at 3%Y, over a time horizon of 5-8 quarters. A tolerance band of +/- 1pp around the target was introduced in March 2015. In the bank's view, inflation is and has always been the NBH's sole target, although the bank describes itself as a "flexible" inflation targeter: in other words, temporary deviations due to cost shocks or one-off impacts are ignored.
Having a band gives the NBH a very wide mandate to interpret the target. Subject to the fulfillment of the inflation target, the bank can focus on financial stability and the economy.
MS also said that, as we will see below, the bank's objectives in recent years went well beyond inflation targeting.
2. What are the NBH's main policy objectives, apart from inflation?
With low inflation 'in the bag', the NBH moved its focus towards reviving credit growth (Funding for Growth, 2013); boosting domestic ownership of the bond market (Self-Financing Scheme, 2014); improving financial stability (FX mortgage conversion in HUF, 2014); detaching Bubor from the 'policy rate' using liquidity management (from 2016:3m depo cap, O/N rate corridor, FX swaps); mortgage bond purchases (ongoing);and an IRS programme aimed at flattening the curve (ongoing).
The list above is not exhaustive, but it shows clearly how the NBH's efforts have gone well beyond its narrow inflation target.
“The bank focused on boosting financial stability, but above all its efforts were on providing a growth-friendly policy backdrop, and loose policy. In the bank's mind, low underlying inflation suggested ample slack and made a very loose policy stance possible.
“A large C/A surplus and the removal of some key external vulnerabilities (e.g. household FX debt, large external debt) allowed the NBH to gain significant degrees of freedom in monetary policy setting. Such negative real rates would simply not have been sustainable in the days when Hungary was running a large C/A deficit and had high external funding needs."
3. How have these objectives changed recently?
In late 2017, the NBH suggested that it was pursuing three objectives.First, to continue to keep policy loose at the front end,anchoring Bubor as close to zero as possible. Second, to use the IRS facility to flatten the yield curve versus peers. And third, to encourage the creation of fixed-rate loans.
It is quite clear that the bank's range of objectives has narrowed since then. The creation of more fixed-term loans was quickly downgraded as a policy goal, and the "increase in the share of loans with long periods of interest rate fixation" disappeared from the statement.
More recently, the reference to relative curve flattening also disappeared from the statement, given the fact that the Hungarian curve has steepened of late under market pressure.
Diana Pasquale, a London-based analyst at Morgan Stanley, believes that the NBH's key and only focus is on keeping low rates for as long as possible, compatible of course with its CPI target. In turn, this allows HUF to remain competitive.
4. How does the NBH think about the FX?
For Hungarian watchers, these have been years of constant changing and learning. But perhaps no change has been so profound as that of the NBH's attitude to HUF. Back in 2012, Hungary's FX sovereign debt was 50% of the total, household FX debt was over 20% of GDP and the FX pass-through was estimated at 25-30%. Right now, FX sovereign debt is a mere 20% of total, household FX debt has disappeared and the FX pass through is around 10-15%
Hungary's overall FX sensitivity has fallen largely as a result of NBH initiatives.
It is therefore by design, and not by accident, that the NBH can take a much more relaxed view of currency developments today compared to the past. The conclusion is that while the NBH is not indifferent to FX, it certainly is not as troubled by FX weakness as it was in the past. And for that reason we are highly sceptical of any notion that there is a 'line in the sand' anywhere near current EURHUF levels. Purely based on inflation-targeting purposes, at present probably any EURHUF rate up to the 345-350 area would still be consistent with the inflation target range. And in addition, the NBH - as any other central bank - cares about volatility and gappy moves. A gradually weakening currency probably does not pose any major concerns. Fast moves based on speculative bets would be more likely to elicit a response.
5. How does the NBH think about the ECB and other central banks?
In official rhetoric, the NBH has often suggested that it is influenced by the ECB. The ECB plans to halt asset purchases in December, which means that its effect on long-end rates in the euro area will be smaller. At the same time, the ECB plans to keep policy on hold at least until summer 2019.
The NBH did not use the size of its balance sheet the way the ECB or other central banks did, and so it does not need to worry about scaling back the use of its balance sheet. However, the NBH is reluctant to allow its own rates to rise much ahead of the ECB, as it fears that raising rates ahead of the ECB may create unwanted HUF appreciation. In that sense, ECB guidance on the first hike is important to the NBH. Overall, the NBH's desire to keep policy loose and pro-growth is so strong that Diana’s best guess is that the bank would aim to lag the ECB, rather than lead it.
6. How does the NBH view the latest market volatility?
With inflation in the vicinity of the 3%Y target and the EM backdrop having turned more challenging, the NBH has had to adopt a more cautious tone.
“At present, we think that the bank views the move in both HUF and interest rates as almost entirely speculative, and therefore not yet needing a strong response in the form of a change in policy."
In a chart pack published with the June rate decision, the NBH showed that speculative positions of foreign investors against HUF increased sharply between March and June. But at the same time, we note that foreign investors' ownership of HGBs has not changed much.
This, combined with the fact that turnover in the FX market has been fairly limited in recent weeks, likely explains why the NBH views the recent HUF underperformance as being driven by short-term speculative bets, rather than a fundamental reassessment of Hungary's macro risk.
Diana thinks that the NBH is therefore much more likely to sit and wait, rather than reacting to speculative bets on the currency.
“We think that the bank is inclined to dismiss this phenomenon as temporary, at least until it sees some capitulation in positioning among long-term bond investors, or more serious FX weakness which puts the CPI target in jeopardy."
Second, it follows that the (related) recent rise in Bubor and FRAs is not something the NBH has 'validated' or accepted. It is something that the NBH views as the result of FX speculative bets and which the NBH is inclined not to react to, at the moment.
Diana still believes that “broader selling of HGBs and associated FX weakness would of course be met with a stronger policy response."
7. What if the next downturn hits and policy rates are still at zero?
While other central banks are taking steps to raise the real interest rate back to positive territory, the NBH is among those that think this is not timely just yet.
“If trade tensions escalate and the economy were to slow down, we think that the NBH would probably provide stimulus via increasing its balance sheet, rather than cutting interest rates."
Note that the NBH balance sheet has been shrinking constantly in recent years. More broadly, the NBH likely rejects the notion that just because rates are at zero, it would have no room for manoeuvre. And this is one of the reasons why it is less worried about normalising rates than other central banks, said Diana.
8. : How would the NBH pursue an exit?
We first need to define what 'exit' really means. “For the purposes of this note, an 'exit' would consist of the NBH guiding Bubor to gravitate back towards the policy rate (0.90%),after which policy would be again run in a conventional fashion, with an actively used policy rate and a symmetric corridor around it," said Diana.
When the NBH decides to guide Bubor higher via its policies, Diana thinks that it will likely to do it in a gradual fashion. For example, raising the cap on the 3M facility (currently the only one that earns 90bp) from the current HUF 75 billion will immediately allow more money to earn higher interest rates. Raising the O/N deposit rate from -0.15% would achieve the same goal; finally, the NBH could decide to lower the amount of money that gets 'crowded out' of the 3M facility, by for example issuing fewer FX swaps. In short, the exit would (unsurprisingly) play out as a slow, gradual unwinding of the tools that have led Bubor to trade well below the policy rate.
9. What communication from the NBH do we need to monitor most closely?
It is clear that the NBH has struck a more cautious tone in recent communication. Diana thinks that future Inflation Report updates and new forecasts will provide the key material for the NBH to reassess its stance.
“Outside these Inflation Report meetings, we would watch how FX and rates trade, stressing that the underlying reasons for market moves would matter a lot. The NBH would probably be far more concerned if it saw large non-resident outflows from the bond market, but it would not feel compelled to react to short-term speculative moves in HUF."
10. When does the NBH expect to return to more conventional policy?
The NBH's has offered guidance that Bubor should start to move towards the base rate in late 2019. Market pricing is of course much more aggressive than this, with the FRAs pricing convergence to the policy rate already in early 2019, followed by conventional rate hikes worth around 90bp by end-2019.
As Morgan Stanley has argued before, the current market pricing for Bubor is a result of a more challenging market backdrop, rather than a major change in NBH policy.
In other words, the market is implicitly assuming that the NBH will move much faster than it now indicates it wants to. As things stand, we are extremely sceptical that the NBH wants to pursue anything close to this pace of normalisation.
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