What will happen to the forint and bonds amid the central bank's interest rate cuts?

There are risks for the forint

Before the one-day deposit rate cuts started, many predicted that it would take the wind out of the sails of the forint, which would therefore start to weaken. So far, this expectation has not materialised, and this is mainly due to the still very high carry (the carry is the difference between the financial yields available in a given currency and in other currencies.) In addition, the fact that the central bank has so far been cautious in its normalisation of the overnight rate, in line with market expectations, and has therefore not given rise to negative surprises for investors, is also supportive. Moreover, this has been accompanied by relatively stern communication, in terms of a commitment to fight inflation and an emphasis on keeping the base rate at 13%. On the positive side, investors may also be encouraged by the fact that central bank policymakers have not wavered after the larger-than-expected slowdown in inflation in May, and have stuck to the 100 basis point reduction rate.

In addition to nominal interest rates, it is also worth paying attention to the real interest rate level, an indicator that is closely watched by institutional investors. Although we are not doing very well in this respect in terms of current interest rates and inflation, the expected future real interest rate is very positive for the forint. By the end of this year, Amundi forecasts that year-on-year inflation could fall to 7.2%, while the central bank base rate could "only" fall to 11.5%, meaning that the real interest rate at the end of the year could be positive at +4.3%! Moreover, it will not only be outstanding in the region - Amundi forecasts that only Hungary will have a positive real interest rate - but will also be among the top performers among developing countries.

The interest rate cut has therefore not broken the forint appreciation trend so far, but it is likely to restrain it in the coming months as the nominal yield spread declines. However, it may still remain attractive, as the policy rate will remain elevated for some time to come and real interest rates will improve, but most of this may have been priced in by now. A sustained strengthening will require a very favourable star position.

The weakening of the forint in recent days has been a sobering reminder to many that there are still substantial risks remaining alongside high carry.

This time, it does not seem to have been triggered by concerns about monetary policy, but by further uncertainty about the sustainability of the budget and EU funding. If the MNB continues on its chosen path of interest rate normalisation, these other factors may predominate in guiding the future path of the forint.

Bond market: falling yields

In the case of bonds, a very simple correlation holds: a cut in the benchmark interest rate tends to reduce yields not only in the shorter maturity segments but also in the longer maturity ones, leading to a rise in the price of bonds traded on the market. Therefore, in addition to the interest rate gain due to the higher coupon levels that have been established, investors holding such bonds also benefit from additional exchange rate gains.

The longer the maturity of the bond held, typically the greater this price gain, with a similar fall in yields.

For bonds traded in the institutional government securities market, investors tend to prepare in advance for interest rate cuts, so yields start to fall earlier (which is why it is important to monitor market expectations of the base rate). This was also observed in the domestic market after the unexpected rate hike by the central bank last October: long yields fell (bond prices rose), although the central bank only actually started to normalise the overnight deposit rate in May this year. For domestic investors, this appreciation is best achieved through bond funds, where fund managers can actively adjust the composition of the funds in line with these expectations. The performance of these funds since October last year has rivalled equity markets: the MAX Index, the benchmark index for funds investing in Hungarian bonds over the year, has returned 27.37% since 14 October, while the BUX Index has gained 26.66% and the US S&P500 Index 23.75%.

Retail government securities do not benefit from this appreciation potential, which is a clear disadvantage (this feature was an advantage last year, however, as institutional bonds suffered a price loss due to interest rate hikes, while retail government securities were not repriced). However, there is another important consequence of the rate cut cycle: over time, the interest rates offered in the retail market will also fall.

In the short term, therefore, domestic bonds seem to have performed quite well, in no small part due to the pricing in of the anticipated start of interest rate cuts.

But is there still any steam left in the market, how much further can yields fall? In thinking about this, it is worth breaking down the factors affecting shorter and longer maturity government bonds. In any case, yields on shorter maturities could continue to fall (i.e. bond prices could rise) as long as the MNB continues to reduce, as short bonds are more closely aligned to the benchmark rate (hence the name) than longer ones.

For bonds on the long side of the yield curve, the impact of the policy rate is less direct, with other structural factors such as inflation, economic growth, developed market yields and general risk perceptions and capital market sentiment being more important. This is also reflected in the current shape of the yield curve, with shorter-term yields much higher than long-term ones. For bonds on the long side of the yield curve, the impact of the policy rate is less direct, with other structural factors such as inflation, economic growth, developed market yields and general risk perceptions and capital market sentiment being more important. This is also reflected in the current shape of the yield curve, with shorter-term yields much higher than the long-term ones. There has also been a positive change in structural factors in the recent period (e.g. falling gas prices in Europe, resulting in a positive current account balance, an advance in the interest rate hike cycles of central banks in developed countries, slowing economic growth, etc.), so further yield declines, i.e. rising bond prices, are still possible in the longer maturities.

If we look at 10-year government bond yields in the region, we can see that Hungarian yields are still the highest in the region, which still represents a higher risk premium than before the Russia-Ukraine war. However, this may be justified in the current situation, given the record inflation and base rates in Europe and the country's economic vulnerability related to energy imports.

However, analyst forecasts suggest that Hungarian inflation could be in line with the regional average by the end of the year, and the central bank could even touch the base rate in the fourth quarter.

Further good news is that the fall in European gas prices has significantly reduced the financing pressure on the current account deficit, but this does not mean that there is not more to be done to reduce Hungary's long-term vulnerability. And a deal on EU funding would go a long way towards further reducing the risk premium in government securities markets.

With regard to the bond market and government bond yields, one should not ignore the developments in recent weeks, where the central bank's interest rate cuts have been accompanied by the government's administrative stimulus measures, which are trying to generate more demand not only for retail but also for institutional government bonds. This could also have a yield depressing effect on bond yields in the longer term, but only if the supply side does not rise, i.e. if we do not see increased issuance volumes by the Government Debt Management Agency (ÁKK) compared to current plans.

This is a realistic possibility, as many analysts doubt the sustainability of this year's and next year's deficit targets, even after the latest announced fiscal austerity measures and tax hikes.

Of course, there are additional risks that could restrain further declines in yields or even cause yields to rise, so the past performance and returns presented above are of course no guarantee for the future. After the recent sharp fall in yields in a short period of time, it would not be unusual for many to opt for profit realisation, as they believe that government bond yields have fallen below fair values. So, after the repricing of recent weeks, the risks are more two-way in the short term, but in the longer term, a fall in inflation and a successful cycle of rate cuts provide a significant tailwind.

So is there still enough steam left in the stock market?

For equities, the most obvious effect of the rate cut cycle is a reduction in the discount rate. This should increase the discounted present value of the resulting profits, so that the value of companies should also increase.

In the above chart, except for the years 2022-23, the relationship between the P/E ratio of the BUX Index and the level of the Retail Price Index is not as strong, but it is clear that equity market investors have not rewarded the Hungarian market with high valuations in a high inflation environment, which is consistent with the experience of developed markets.

This is clearer in some sectors, such as telecoms or public utilities, where most of the revenue is predictable, fixed and fee-based. These are very similar to interest payments on a bond, so a reduction in the interest rate environment is associated with a rise in the valuation, as the textbook example suggests.

The situation is less clear for the banking sector, where rising interest rates generally benefit financial institutions, but the recessionary environment less so.

By default, an inverted yield curve is not good for the banking system (where high interest rates are needed to finance lower long-term loans), but domestic banks currently raise most of their funds through retail deposits, on which they pay little interest. The reason for this becomes obvious when one considers that they do not need this source of funding (the loan-to-deposit ratio is well below 100%) to the extent that they did in the past (on the eve of the 2008 crisis, the ratio was typically above 100% for domestic banks). Therefore, if the falling benchmark interest rate were to have a greater impact on short-side interest rates than on long-side interest rates, i.e. if the slope of the yield curve were to increase, this could even be a positive development for banks. Especially if the easing of monetary tightening were to lead to a resumption of lending and the economy were to emerge from the recession that started in the third quarter of 2022.

For the other sectors, it is mainly the general easing of interest rate conditions and the resulting resumption of economic activity that could be decisive in the future, and the impact of interest rate cuts cannot be directly measured beyond the change in the discount rate used to value companies.

Positive rather than negative

Overall, it seems that the interest rate cuts are having a positive rather than negative impact on asset prices, and there is still room for further improvement in the long run, even after the good performance of recent months. At the same time, it should be remembered that a given path of rate cuts has already been priced in by the market, and in the future it will not be the actions taken but surprises that will affect the price of individual capital market assets, diverting the actual path from what was previously expected. These can of course be positive or negative. However, now that the easing of monetary conditions that everyone has been waiting for has started, it is worth paying particular attention to the risk factors outlined above, and the two-way risks mean that portfolios cannot be put on autopilot for any asset class.

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