While interest rates are higher in the US, Norway has seen the largest increase this year, 55 basis points for 2-year government bonds and a full 60 basis points for 10-year bonds. That may not be a coincidence.
For a small country like Norway, the task of bringing down inflation comes with an added complication: reducing or eliminating inflationary impulses from a weak currency. As it happens, the international value of the Norwegian krone (the effective exchange rate) has fallen by some 30 per cent over the past decade, or just shy of 25 per cent if we adjust for inflation differentials (the real effective exchange rate). It fell last year, too, just as Norges Bank was busy fighting inflation.
This is where interest rates come into play. Over the past 15 years, there is a strong correlation – in excess of 0.8 – between the USDNOK rate and the interest differential on short maturities (both 1 and 2 years). There’s a similar pattern for Swedish kroner, by the way, but I’ll limit myself to Norway here. A univariate regression indicates that this interest rate differential, the carry, explains almost 70 per cent of the variation in the USDNOK rate. The oil price turns out to be redundant.
Presently, the carry is negative; rates are higher in the US. At the very least, Norges Bank will not want to see an even more negative carry, meaning that they will, or should, delay cutting the policy rate at least until the Federal Reserve does. ECB policy decisions are not irrelevant but, historically, dollar rates seem to matter more than euro rates.
So … not only are expected rate cuts pushed further into the future. On top of this, Norges Bank will have to be even more patient. In short, I’m not first in line of those heralding future rate cuts.
Bad news? Not at all. For one, it is likely to improve returns on our fixed-income portfolios of predominantly floating-rate notes. And in our equity portfolios, the large number of companies with strong balance sheets and modest leverage will strengthen their position in this rate environment.
Besides, wouldn’t you agree that the stock market is overly sensitive to interest rates? If rate cuts are delayed by six or perhaps twelve months, does that really make much of a dent in the value of all future earnings? In my view, it is rather a sign of a robust economy.
There are, apparently, many investors who agree. In February, despite obviously lowered rate cut expectations, high-yield spreads tightened and the MSCI World Index rose by 4.6 per cent in local currency. In Norwegian kroner, it rose by 5.8 per cent, inflated by – you got it – a weaker currency.
I rest my case.
Finn Øystein Bergh
Chief Economist & Strategist
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