BNP Paribas:
If the ECB were to intervene, this would significantly change the mindset of any investors seeking to profit from realignment. While the official fluctuation limits are ± 2.25% around the target, the reality is that there is a band within a band, as the exchange is generally maintained at ± 0.5% around the target (Chart 6). What this means is that any speculator betting against the peg holding stands to lose 0.5% of the money pledged. If the peg is abandoned, the currency is likely to surge by at least 10%. Upside potential of 10% versus downside potential of 0.5% is a 20-to-1 bet. Thus, as long as an investor thinks there is an above 5% chance of a revaluation, this is a value play. The prospect of betting against the ECB would change the calculus on the perceived chance of success. More fundamental changes The option that everyone is fighting to avoid is realignment or the full abandonment of the currency peg.
The central bank is arguing vociferously that this option is completely off the table. The bank is hoping that it is just witnessing a temporary shift in asset allocation preferences, as this is something which it can probably ride out. The change in asset preference may be permanent, however. What’s more, the exchange rate may be structurally inappropriate for the economy, as the current account balance has been rising and is now in surplus to the tune of 7% of GDP. Shortly after the peg was introduced 30 years ago, the country had a current account deficit of about 5%. The present economic environment is a difficult one in which to evaluate the appropriate fundamental exchange rate for an economy but the current account surplus may point to a currency which is too weak. The final option would be to opt for full membership of the euro. The Danes rejected this option in a referendum in 2000 but there are some clear benefits to this approach. If the peg is truly the keystone of Danish economic policy, surely this is the easiest way to embed that. Currency risk versus the euro would disappear and pension funds would have a far greater pool of assets and liabilities which can be matched. This is not a solution in the short term, however, as a referendum cannot be held overnight and the outcome cannot be guaranteed. Indeed, Danes have demonstrated a significant degree of euro-scepticism in the past and their relationship with the EU has been difficult at times. Demark has required concessions to pass European treaties and its progressive tightening of immigration laws means that its rules are stricter than the norm in Europe. On this basis, the political hurdles for euro membership remain quite sizable. The bottom line The primacy of the peg in Danish economic and political life means that it will be staunchly defended. We think another rate cut is imminent, most likely after today’s T-bill auction. Thus, any time between now and Monday 16 February is a strong possibility for a cut. The fourth and most recent rate cut was 25bp and was larger than the previous three, which were all 15bp. We think the next cut will also be 25bp, bringing the deposit rate to -1%. We see the terminal rate at -1.25%. Spreads in policy rates and yields versus eurozone equivalents are now at their lowest recorded values. From here, further cuts should have greater traction both in terms of the negative carry for investors and discouraging further inflows from pension funds. It’s possible the central bank could go for a shock move and take rates lower, say to -2.0%, but we think the problems this would cause domestically mean that it could only be sustained for a short time. Even a deposit rate of -1.25% is likely to cause problems. Accordingly, our central view is that intervention coupled with the deposit rate cuts should eventually ease the pressure on the DKK. If we are wrong, it seems like revaluation is the eventual alternative as the time and political willingness needed to join the euro are just not there. Even if we are right, the viability and appropriateness of the current peg need a thorough evaluation by Danish authorities.
