Investment Research — General Market Conditions
21 March 2014
Research DKK
Vagueness in the CB reaction function
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

The lack of action from Danmarks Nationalbank over the recent period of krone
weakening could be a subtle indication that the reaction function of Danmarks
Nationalbank has changed under the new governor Lars Rohde.
In an article about its reaction function in its Q1 quarterly review, Danmarks
Nationalbank emphasised the need for a certain level of vagueness in the reaction
function.
This may contribute to explaining why Danmarks Nationalbank has stayed on
the sideline in Rohde’s first 13 months as governor – a remarkable record given
the historical frequency of central bank intervention; on average his two
predecessors intervened more often than every second month during their terms.

Hence, so far, Rohde has relied on the market to determine the EUR/DKK
exchange rate freely and, therefore, presented himself as a less activist central
bank governor than his predecessors.

One important argument for the absence of intervention even though EUR/DKK
is at the highest level in many years, and thus an argument for vagueness in the
reaction function, is the current strong support the krone is getting from the
large external surplus, which puts appreciation pressure on the krone.

In addition to this, the large currency reserve, currently above DKK475bn or
26% of GDP, provides the central bank with substantially more ammunition to
stabilise the krone on the weak side of the central rate. Hence, EUR/DKK above
the central rate may be less worrisome to Danmarks Nationalbank now than it
was previously.

Hence, with the support from the large external surplus and the currency
reserve in the background, we believe it makes sense for Danmarks
Nationalbank to remain sidelined in the current situation. If this is the central
bank’s strategy, it greatly reduces the risk of a near-term independent rate hike.
Contents
A regime change under way? ................ 2
Rohde on the sideline ................................. 3
Assessing the reaction function ......... 3
Strong balances support the krone .. 4
Vagueness in the reaction function
may postpone rate hike ............................. 5
Appendix: Independent rate hikes ...... 7
EUR/DKK fixing at eight year high
Source: Macrobond
Lars Rohde has now been governor of Danmarks Nationalbank for 13 months. Over the
entire period, the central bank has stayed on the sideline even though since mid-January
EUR/DKK has risen to levels that have historically triggered intervention. The lack of
action during this recent krone weakening trend may be a subtle hint that the reaction
function of Danmarks Nationalbank has changed under Lars Rohde.
In this document we reassess the reaction function of Danmarks Nationalbank. First, we
look at how Danmarks Nationalbank has reacted historically to a weakening of the krone.
Second, we take a look at Denmark’s external balances and further argue that it would
make sense for Danmarks Nationalbank to allow some vagueness in its reaction function
at the present time.
Analyst
Jens Nærvig Pedersen
+45 4512 8061
[email protected]
Important disclosures and certifications are contained from page 8 of this report.
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A regime change under way?
In an article on its reaction function in its Q1 quarterly review Danmarks Nationalbank
emphasised the following (Danske Bank’s translation).

‘Danmarks Nationalbank’s reaction function is well-known by the market
participants’.

‘...that this credibility has acted as a stabilising factor, which has reduced the need for
central bank intervention’.

‘Danmarks Nationalbank has a sizable currency reserve’.

‘It is important that Danmarks Nationalbank is free to act according to the present
circumstances’.

‘There is no regular pattern in terms of the spot level that triggers intervention and the
level of intervention it takes before an interest rate increase takes place’.

‘A certain level of vagueness in the use of its instruments is allowed depending on the
concrete situation in the FX market’.
At the press conference following the release of the report these points were reiterated by
Rohde and in a following Bloomberg interview he furthermore hinted that he views the
recent weakening of the krone as mainly a ‘technicality’ due to higher euro rates.
Note that Danmarks Nationalbank is not obliged to write about its reaction function nor to
answer questions on monetary policy.
The above may suggest that the regime under Rohde is in no hurry to push the
intervention button at the current level for EUR/DKK above 7.4640, which could be
interpreted as a departure from the reaction function under past governors.
Note that the official ERM2 fluctuation band for EUR/DKK is 7.46038 +/-2.25%, which
put the high end of the band at 7.62824. Historically, we have seen the EUR/DKK fixing
move as high as 7.4684 at one point under previous governor Bodil Nyboe Andersen and
at 7.4674 at one point under governor Nils Bernstein.
De facto EUR/DKK trading band under different central bank governors
Source: Macrobond, Danske Bank Markets
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Rohde on the sideline
To maintain the exchange rate close to the central rate, Danmarks Nationalbank uses
mainly its two primary instruments: intervention in the FX market and interest rate
changes. While a unilateral interest rate change is a less common event, Danmarks
Nationalbank has in the past frequently intervened in the FX market to support the pegged
exchange rate.
Over the 182 months since January 1999, Danmarks Nationalbank has intervened in 103 of
them and in 39 of the months it has purchased kroner and thereby lowered the currency
reserve. While Rohde has yet to make his first appearance in the market, there was little
difference between how often his two predecessors had to intervene. While Nyboe
Andersen intervened in 66% of the months of her term, Bernstein had to intervene in 56%
of the months he held the position as governor. In 39% and 35% of the time respectively,
they intervened by purchasing kroner.
Frequent central bank intervention
In this respect, it is quite remarkable that Rohde has been on the sideline for the 13
months he has so far held the position as governor. It marks the longest period without
any intervention from Danmarks Nationalbank since the euro was adopted.
Source: Danmarks Nationalbank
What makes the current situation further noteworthy is that the recent move up in
EUR/DKK did not trigger intervention in January and February. Historically, Danmarks
Nationalbank has in all but four months when the EUR/DKK fixing has been above
7.4620 stepped into the FX market and purchased kroner. This was not the case in either
January or February this year.
Hence, Lars Rohde has so far relied on the market to determine the EUR/DKK exchange
rate freely.
Danmarks Nationalbank normally buys kroner when the EUR/DKK fixing is above
7.4620
Source: Danmarks Nationalbank
Assessing the reaction function
If we look at the intervention leading up to previous independent rate increases, it has varied
between DKK7bn and DKK64bn within the month of the rate increase and between
DKK4bn and DKK65bn accumulated in the three months leading up to the increase. See the
Appendix to this document for a complete list of independent rate increases since 1999.
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In five out the nine instances when Danmarks Nationalbank increased interest rates
unilaterally, the total net intervention within the month of the rate increase was between
DKK7bn and DKK12bn and DKK4bn and DKK19bn accumulated in the three months
leading up to the increase. Note further that in one instance, in October 2010, Danmarks
Nationalbank increased interest rates without prior intervention.
In October 2008, Danmarks Nationalbank intervened by around DKK64bn and raised
interest rates unilaterally twice. However, this situation can best be described as
extraordinary following the collapse of Lehman Brothers and the escalation of the
economic crisis.
The highest the EUR/DKK fixing has been during the week leading up to the independent
rate increases is between 7.4576 and 7.4663. In three out of the nine unilateral rate
increases since 1999, the EUR/DKK fixing was not above the central rate of 7.46038
during the week leading up to the rate hike.
As the chart above furthermore illustrates, history also presents a number of examples
where EUR/DKK has been above the central rate and Danmarks Nationalbank has
intervened without raising interest rates afterwards. In January 2001, July 2005, October
2005 and December 2007, we saw net intervention purchases of kroner for around
DKK11-12bn when EUR/DKK was above the central rate. However, in all four cases, the
intervention was sufficient to bring down EUR/DKK towards the central rate. In the
period March to May 2001 EUR/DKK was persistently allowed to trade relatively high
above the central rate without Danmarks Nationalbank taking action.
Overall, the sample of independent rate hikes is too little to state anything significant
about the reaction function of Danmarks Nationalbank. However, in four out of nine
cases, it has raised interest rates when EUR/DKK is above the central rate and prior
interventions have accumulated to around DKK15-20bn.
Strong balances support the krone
The strong balances in the Danish economy may support an argument for Danmarks
Nationalbank allowing some vagueness in its reaction function at the current stage and
therefore not rushing into taking action despite EUR/DKK being at the highest level in
many years.
The surplus on the current account balance reached DKK136bn in 2013. The mounting
surplus now exceeds 7% of GDP – the largest surplus in more than 60 years of available
data. Furthermore, there is currently a large surplus on the balance for portfolio
investment, which amounts to around 3% of GDP. Hence, even though there is a slight
deficit on the balance for direct investment, Denmark currently has a surplus on its broad
balance of payments of more than 9% of GDP. The surplus creates a fundamental demand
for kroner and thereby puts appreciation pressure on the krone.
Furthermore, seasonal factors will begin to support the krone as well in coming months.
Normally, seasonal factors weigh on the current account balance in the winter months and
early spring – especially in March, when Danish firms normally pay dividends to foreign
shareholders. Over the summer and during the autumn, seasonal factors support the
current account surplus, on the other hand.
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Record-high current account surplus
Source: Statistics Denmark, Danske Bank
Markets
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The booming currency reserve is another factor that supports the krone and leaves less
pressure on Danmarks Nationalbank to take action. Currently, Danmarks Nationalbank
holds more than DKK475bn in currency reserves, which amounts to more than 26% of
GDP. This is substantially more than in 2008 when the currency reserve fell to
DKK132bn in October following more than DKK60bn of intervention amid significant
pressure on the krone from the escalation of the economic crisis. Hence, Danmarks
Nationalbank has significantly more fire power now than it has had previously, which
should make EUR/DKK on the weak side of the central rate less worrisome to the central
bank.
Mounting external surplus
Currency reserves have grown since
2008
Source: Statistics Denmark, Danske Bank Markets
Source: Danmarks Nationalbank, Statistics
Denmark, Danske Bank Markets
Vagueness in the reaction function may postpone rate hike
Based on our assessment of Danmarks Nationalbank’s historic reaction function the lack
of action from the central bank during the recent period of krone weakening could be seen
as a slight departure from the behaviour we have witnessed in the past. This could be a
subtle indication that the central bank under governor Lars Rohde will rely more on the
market in the determination of the EUR/DKK exchange rate.
Rohde’s emphasis on the need for a certain level of vagueness in the central bank’s
reaction function may help to explain why no intervention took place in January and
February when the krone weakened. The krone is currently getting strong support from a
large external surplus and furthermore the large currency reserve means the central bank
has less to worry about when EUR/DKK is on the weak side of the central rate.
Therefore, it would make good sense for Danmarks Nationalbank to let the market do the
lifting at the current stage and stay out of the market, although this may be somewhat of a
departure from its previous reaction function. However, the support from the external
surplus and the currency reserve is also exceptional. Hence, if March’s currency reserve
figure, due for release on 2 April, shows that Danmarks Nationalbank did not intervene in
March either, then we believe the likelihood of a near-term unilateral Danish rate hike is
greatly reduced.
Furthermore, as Denmark will likely continue to hold a strong external position, the
implication of the presence of a new reaction function could mean that Danmarks
Nationalbank, everything else equal, will be more hesitant to raise rates in 2014 and 2015.
This further means that the pace of normalisation of the Danish money market rates will
likely be slower than what is currently priced in the Danish CITA forward market – see
chart below.
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New reaction function and strong external balances indicates that the Danish CITA
forward curve is too steep
Source: Danske Bank Markets
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Appendix: Independent rate hikes
Unilateral interest increases since 1999
Date
Governor Rate change EUR/DKK 1W high
3M carry 1M
1M int., 3M int.,
(1W avg.), Chg,
DKKbn DKKbn
bp
bp
08/06/00 Andersen
Lending and
CD rate by
60bp, CA and
discount rate
by 50bp
7.4639
7.4639
-10.5
-14.1
52
23
29/09/00 Andersen
Lending and
CD rate by
50bp
7.4562
7.4653
-10.5
-14.6
132
51
17/02/06 Bernstein
Lending and
CD rate by
10bp
7.4653
7.4663
-34.0
-29.6
0
0
16/05/08 Bernstein
Lending and
CD rate by
10bp
7.4604
7.4628
-11.8
-19.4
-2
0
07/10/08 Bernstein
Lending and
CD rate by
40bp, CA and
discount rate
by 25bp
7.4623
7.4623
-63.9
-64.6
-14
-24
24/10/08 Bernstein
Lending and
CD rate by
50bp
7.4565
7.4576
-63.9
-64.6
18
25
14/10/10 Bernstein
CD and CA
rate by 10bp
7.4571
7.4577
-7.3
-3.9
-19
-13
28/10/10 Bernstein
CD and CA
rate by 10bp
7.4585
7.4585
-7.3
-3.9
-23
-18
24/01/13 Bernstein
Lending and
CD rate by
10bp
7.4620
7.4636
-11.9
-16.0
-16
15
DN comment
The interest rate increase should be
viewed mainly against the background
of the European Central Bank's raising
of interest rates of 0.50 per cent.
However, the Nationalbank raises the
lending rate and the interest rate on
certificates of deposit by a little more
than the ECBs rate increases. The
reason is that during recent months
the Nationalbank has sold foreign
exchange, and since 30 May for around
DKK 10 billion.
The Dansih fixed-exchange rate policy
will be maintained after yesterday's
referendum. There has recently been
some pressure against the Danish
krone. This has resulted in short-term
interest rates that are significantly
higher than the Nationalbank's official
interest rates, and intervention in
support of the krone by the
Nationalbank.
The increase by 10 basis points is due
to an outflow of foreign exchange in
February, among other things as a
result of Danish institutional investors'
purchase of foreign shares and other
securities. In accordance with the fixedexchange-rate policy Danmarks
Nationalbank has intervened to support
the krone. The interest-rate increase is
intended to make placements in kroner
more advantageous. Danmarks
Nationalbank emphasisesthat the
outflow of capital does not reflect a
weakening of the Danish economy.
Since August 2007 the spread
between Danmarks Nationalbank's
lending rate and ECB's marginal rate
has been reduced with 15-20 basis
points, thus the spread has more or
less disappeared. In short periods of
time the interest-rate spread has been
negative. The development of the
interest-rate spread has led to a
weakening of the Danish krone, and in
accordance with the fixed-exchangerate policy Danmarks Nationalbank has
intervened to support the krone.
Since mid-September there has been
an increase in ECB's marginal rate. This
has reduced the spread between
Danmarks Nationalbank's lending rate
and ECB's marginal rate. Recently the
interest-rate spread has been negative,
which has led to an outflow of foreignexchange. Danmarks Nationalbank has
intervened in the foreign-exchange
market to support the krone. The
intervention has now reached a point
which leads to Danmarks
Nationalbank's increase of the lending
rate. The size of the change in the
interest rate reflects the need to reestablish a positive interest-rate
spread.
As a result of continued intervention to
support the Danish krone,
The interest rate increase is due to a
raise in the short European market
rates compared to the equivalent
Danish market rates. This development
has weakened the krone, and Danmarks
Nationalbank has intervened in the
foreign exchange market to support the
krone.
The interest rate increase is due to a
rise in the short-term European market
rates compared to the equivalent
Danish market rates.
The interest rate increase follows
Danmarks Nationalbank's sale of
foreign exchange in the market.
Source: Macrobond, Danmarks Nationalbank, Danske Bank Markets
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Disclosures
This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske
Bank’). The author of this research report is Jens Nærvig Pedersen, Analyst.
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