If we're not careful, the old story on forint weakening will be back

There are a number of high-quality analyses in the Portfolio columns on the factors that could affect the forint exchange rate in the coming months (including by Zoltán Árokszállási, Dávid Németh and Zoltán Török).

Much is said about the monetary policy of the major central banks, the domestic fiscal situation, the fate of EU funds, the expected evolution of inflation or even the interest rate differential with the regional central banks.

Numbers, numbers, numbers.

There is, however, one factor that is difficult to quantify, but is perhaps as important as any of the factors listed above. And that is the narrative, the "story" that economic agents form in their minds about the attitude of economic policy makers towards the forint.

In order to understand the details, it is important to briefly discuss both the theoretical and the practical background.

In the case of economies, the theoretical importance of narratives was highlighted by Nobel Prize winner Robert Shiller. Emphasising the importance of psychological factors rather than a worldview based on rational human beings, Shiller sees the role of narratives, which emerge from time to time and then spread like a virus, as crucial in capital markets.

Why do we think that property prices never fall? Why do companies often get jittery at the same time and cut back their investments, causing a widespread economic recession? Why do investors fall in love with a stock, triggering incredible price rises? And then why do they often fall out of it just as quickly?

In many cases, not because of facts and figures. Based on the economic history of the past decades, Shiller's conclusion is clear: the impact of the stories and histories that spread in society is often very significant.

So much so that, if future processes are to be understood, the evolution and propagation of these narratives - which will ultimately influence the decisions and behaviour of economic agents - must be taken into account by investors as much as by economic policy makers (it is no coincidence that one of the main skills of central bankers is to consciously influence them through communication and expectation management). Sometimes emotions are just as uninterested in facts as facts are uninterested in emotions.

Of course, it would be an exaggeration to claim that economic processes are driven only by narratives and that economic facts are irrelevant. This is obviously not true, prices and exchange rates typically revert to fundamentals in the long run. The question is how tangible are the fundamentals that help this adjustment for a given instrument.

A peculiarity of the foreign exchange market is that, unlike, say, the bond or stock markets, the fundamentals to which one is supposed to be aligned are less clear, so we still do not have really good foreign exchange forecasting models, despite the various methodological approaches.

Therefore

1. short-term exchange rate forecasts are legendarily inaccurate;
2. the relative role of stories, technical levels, positioning and flow effects in short-term FX movements is perhaps greater than in other segments of the capital markets, relative to fundamentals.

The practical relevance of the narratives on the outlook for the forint is given by what happened in autumn 2022. The central bank's extraordinary rate hike at the time effectively stabilised the forint exchange rate, and I believe that this may have been a key reason. Namely, the MNB successfully created a new dominant narrative or at least offered an alternative story to the existing one.

Of course, the new narrative required a lot of things - the interest rate premium, which was outstanding even by regional standards, the strong messages that have been going on ever since, etc. - but the main result was that something "clicked" in the minds of many economic agents.

Many players started to believe in a new story: the narrative of the previous years, which had led to spontaneous euroisation ("the forint will always weaken, and economic policy makers have come to terms with this"), was replaced by a new one, in which the central bank took firm action to protect the domestic currency from uncontrolled depreciation.

A new story in which, even if it comes at a price, the stability of the forint exchange rate is an economic value that is a priority in the minds of policy makers.

Of course, it is difficult to quantify this effect, but in talking to many of my fellow investors recently, I have felt this change in perspective.

Of course, and it is important to stress this again, the spread of the new narrative would not have been possible without high interest rates, but the fact that the forint was able to remain relatively stable between the end of 2022 and the beginning of 2024 was due to the market's belief that the central bank wanted the forint to remain stable.

How this narrative evolves in the period ahead is therefore critical for the future prospects of the forint. In the light of the forint's easing in recent weeks and the central bank and government's sporadic remarks on the outlook for monetary policy, everyone is wondering whether the old narrative will return or whether the new one, which the market has been slowly but surely starting to believe since autumn 2022, will remain.

Of course, it is extremely difficult to discern the evolution of changing narratives. Investors read with a wary eye every central bank commentary, interpret every government statement. Looking for messages between the lines as much as interpreting the meaning of the actual words.

• Will the central bank slow down the pace of interest rate cuts if the forint weakens further?
• What are the communication signals coming from the various decision-making centres of domestic economic policy on priorities?
• How are these real or perceived messages decoded/interpreted by the investment community?

These, along with interest rates, global developments and all the other fundamentals, will be the factors that will drive the exchange rate.

If the new narrative, which is now a year and a half old, cannot dominate the exchanges among friends, the board meetings on corporate decisions and the investor meetings in London and New York, there is a good chance that the old story will return.

 Because a story that economic actors can cling to at their own decision-making level, a story one can believe in, is always needed.

 And we already know the old story: the forint will weaken.

This story originally appeared on Portfolio's opinion column, 'On the Other Hand' (in Hungarian). The articles reflect the views of the authors, which do not necessarily coincide with the views of the Portfolio editorial team.

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