Weaker euro despite rising inflation

Due to high and rising inflation Chinese authorities once again raised their reserve requirement. In

(18.04.2011) Due to high and rising inflation Chinese authorities once again raised their reserve requirement. In Europe and the US prices are also rising, but this has had a very different effect on monetary policy. The Norwegian krone has strengthened since our last report, but is expected to weaken short term.

By Maren Romstad, Analyst at DNB Markets

Rising inflation expectations, partly as a result of high food and energy prices, has received increasing attention recently. Towards the end of last week we got price figures from China, which once again showed that inflation is well above the government target set for this year. As a consequence, the Chinese government once again raised the reserve requirement to banks to fight the rising inflation.

On Friday other indicators showing that inflation is increasing were published. In the euro zone inflation rose from 2.4 in February to 2.7 per cent in March, and, thus, puts additional pressure on the European Central Bank. The ECB is particularly concerned about preventing second-round effects due to higher energy prices, in other words the price growth spilling over to underlying inflation. This was also a tendency we observed on Friday, as core inflation rose from 1.1 to 1.5 per cent. However, details gave few reasons to worry, as almost all of the increase can be attributed to increase in prices on clothing. These are often quite volatile and part of the increase could easily be reversed next month.

Inflation figures from the US also showed higher prices
, both for total and core. However, core inflation is still low and below what Fed sees as desirable. The annual growth in consumer prices is currently the same for the US and the euro area, but Fed shows no signs to hike interest rates anytime soon. The difference between the two central banks is that the ECB has a greater focus on total inflation. In addition, they seem more concerned about second round effects.

Despite the surprisingly high inflation in the euro zone, the common European currency has weakened on a broad basis since Friday morning. The euro weakness can probably be explained by another round of debt turmoil after another downgrade of Irish government debt and a possible restructuring of the Greek debt.

In recent months the euro has been more or less immune to news about the debt situation in Europe. This may be because a lot of negative news already have been taken into account, but can also be a result market's focusing on monetary policy and interest rate differentials. Today IMF, ECB and the European Commission start their negotiations with Portugal, which will attract some attention in the media. The market reaction is more uncertain as a result of the euro's response pattern in recent months.

On Wednesday the Swedish central bank meets, and both we and consensus expect a hike of 25 basis points to 1.75 in line with the Riksbank's own interest rate path.

The minutes from the Bank of England's last policy meeting are also published on Wednesday. BoE has been very uncertain in the past, and many new signals are unlikely this time. We expect a split interest rate committee as previously. It is also worth noting that the result season has started.

The Norwegian krone has strengthened since our last report, without there being any obvious drivers. However, we expect that the krone may weaken in the short run. Hence, we have adjusted our forecast for EURNOK in one month. The potential of a weaker NOK is due to dividend and coupon payments, bond maturing and the possibility of foreign exchange purchases for the Government Pension Fund in May.

In the middle of the month a government loan (NST469) at 46 billion Norwegian kroner is maturing. Foreign investors are currently holding 80 per cent. In addition, coupon payments on the remaining loans are expected to pay out 8 billion. From the bond market foreign banks can potentially earn around 45 billion NOK in May, which potentially can be taken home. Most likely a considerable amount will be reinvested, but there is also the risk of NOK selling during the next month.

Furthermore, based on a higher oil price and budget estimates for 2011, we expect Norges Bank to start buying FX to the Government Pension Fund. Norges Bank has not bought currency to the fund since November last year. However, it is uncertain how large the effect of currency purchases is on the Norwegian krone, but if anything it should be negative for NOK. In the longer term we still expect that the Norwegian krone to be stronger against the euro, but we see that is the possibility of a weaker krone in the next month. Hence, we have adjusted our forecast for EURNOK up to 8.00 in a one month horizon.