Disinflation risk amp FX performance

What is the best Forex combination out of the 11 most liquid currencies as far as currency performance so far this year? Long Aussie, short Swedish Krona yielded 13% year-to-date. This is the second best combination behind going long NZDSEK. Eight weeks ago, we had predicted here the AUDSEK reaching 6.4 “would be in order for this summer”. The rationale was based on inevitable Riksbank easing and Aussie rebound as the RBA gave up on talking down the currency.

This has materialised as the Riksbank delivered its shock rate cut while the RBA kept its hands off the rebounding Aussie. So what’s next?

The chart below shows the inflation trend of low inflation countries and the percentage change in their currencies against the USD since July last year. This month’s 50-basis-point cut from the Riksbank was a surprise in its magnitude as most market observers had been expecting a 25-basis-point move. But the central bank, long criticised for falling behind on its 2% inflation target, was forced to prioritise price stability, causing the governor to be outvoted by four members opting for the more 50-basis-point cut.

Will the Norges follow the Riksbank?

As Norway’s Norges contends with record low rates in Sweden and the eurozone, it raises the question about whether the central bank will be forced to ease in response. Recent manufacturing figures may suggest Q2 GDP to slow near 0.5% from 1.1% in Q1, but this may not be sufficient to prompt a rate move as the currency is currently markedly weaker than the Norges had anticipated. Going forward, however, we may have seen the top in NOKSEK around 1.13, which would later be followed by a gradual retreat towards 1.07 as the Norges eases its policy bias. Norway’s federal finances and current account situation are among the strongest in the world, but with higher inflation, interest rates are among the lowest. This may suggest interest may have to be forced lower from their current 1.50% in the event that the robust currency starts importing lower prices.

How about Danish & Swissy?

In the case of Denmark, the central bank’s discount rate target stood at 0% since July 2012 in response to an average inflation rate of 0.50% over the last 12 months. This kept bond yields at below 2.0% on a combination of low inflation and low growth drifting below 1.5% over the past three years. Denmark’s currency has outperformed both the SEK & NOK despite its ultra low rates as the situation prevailed for well over two years. The novelty of the shock rate cut from Sweden and the potential for an easing down the road from Norway may well be behind the recent resilience in DKK.

In Switzerland, annual CPI has dipped back to zero and the harmonised CPI adopted by the Eurostat is at -0.1%. Meanwhile, retail sales fell 0.6% in the year ending in May. Yet the currency remains resilient due to safe haven flows from lingering uncertainty in Ukraine.

Currencies have proven to us time and again that profit optimisation is best derived from the forward-looking interest rate horizon, rather than the prevailing picture. With that logic, SEK shorts may remain attractive against USD and AUD into mid Q3, until the focus leans towards a more bearish stance in NOK as the Norges is forced to embrace a more dovish directive.  6.7 in USDNOK and 6.05 in CADNOK are among the likely targets for this year in these low inflation pairs.