Denmark: Entering the Tightening Cycle

Author: Mikko Forss  ·  October 22nd, 2010  ·  259856http%3A%2F%2Fwww.economonitor.com%2Fanalysts%2F2010%2F10%2F22%2Fdenmark-entering-the-tightening-cycle%2FDenmark%3A+Entering+the+Tightening+Cycle2010-10-22+09%3A52%3A19Mikko+Forsshttp%3A%2F%2Fwww.economonitor.com%2Fanalysts%2F2010%2F10%2F22%2Fdenmark-entering-the-tightening-cycle%2F › Share This Print

Denmark’s central bank hiked its deposit rate by 10 basis points to 0.6% on October 14, 2010, to support the depreciating Danish krone (DKK), which is pegged to the euro. However, the DKK has continued to weaken, implying that more deposit rate hikes could soon take place.

Due to excess liquidity in the eurozone, money market rates in the single currency area have followed the ECB’s deposit rate, which has stood at 0.25% since April 2009. The equivalent Danish rate has remained much higher than the ECB deposit rate, causing inflows to Denmark and prompting the country’s central bank to cut the deposit rate on several occasions, most recently in May 2010.

However, the recent liquidity withdrawal in the eurozone has caused eurozone money market rates to spike. The effective EONIA overnight rate stood at 0.84% on October 20—more than double the rate just three weeks earlier—and is now higher than the corresponding Danish rate (T/N rate). The unsecured three-month interbank lending rate (EURIBOR) is also edging steadily upwards, narrowing the gap to the corresponding Danish rate (CIBOR). The tighter spreads have made the DKK less attractive and have led to outflows, causing the currency to weaken close to the central parity of 7.46 to the euro.

CIBOR-EURIBOR Spread, EUR/DKK, Central Parity at Which DKK Is Pegged to EUR

Source: Factset, RGE

The last time the DKK was weaker than the central parity—the EUR/DKK pegged exchange rate—was in early October 2008 in the wake of the Lehman collapse, prompting rate hikes from the central bank. We expect more deposit rate hikes to take place soon given the recent narrowing between the Danish and eurozone rates. However, hikes in the lending rate are not likely until the deposit rate is hiked to the same level (to 1.05%). Traditionally, these two rates have been the same. The pace of tightening will depend on how quickly eurozone money market rates rise. (See related Critical Issue on Danish Monetary Policy.)

For more on European monetary policy, read “Europe Focus: Monetary Policy in Denmark and UK; German Exports; Turkish Bank Lending,” available exclusively to RGE Clients.