Sterling, the SEK and the NOK

People are beginning to ask whether it is the beginning of the end for sterling. Having fallen sharply in the not too distant past, there are signs of a possible softening of the housing market and increased fears of a sharp weakening of consumer spending and economic growth more generally.

Retail sales have been weak while industrial production has also disappointed. However, continued strong growth in real average earnings should support consumption, and our economists still think it unlikely that we will see a major decline in sterling in the near term, at least against the dollar.

The rise in sterling in late 2003 took it back to the highs seen in early 2002, but the past month has seen it fall back sharply.

The main reason for this sell-off has been signs that the housing market may be cooling after a period of very strong activity and sharply rising prices. The RICS survey, mortgage lending data and the house price indices have all suggested that the market was somewhat weaker.

The FX market has extrapolated this into a more substantial turn in the housing market, a weakening of consumer spending, an overall economic slowdown, a reversal of Bank of England policy, and hence a large potential fall in sterling.

However, while sterling would certainly be vulnerable to such a sequence of events, some of the links in the chain are still missing. Even if the housing market really is slowing substantially, consumer spending will not necessarily collapse.

When analysing UK average earnings growth deflated by the CPI to give a measure of real earnings growth, we will find that this has been on a rising trend as the labour market has continued to tighten and inflation has remained very subdued. This should support consumption even with a less robust housing market.

The other missing link in the chain is the sharp fall in relative interest rate expectations that would probably be needed before sterling turns lower on a sustained basis.

We believe the dollar is being supported by a belief that the Fed will continue to raise rates, despite softer economic data.

Should this perception change, the dollar's decline could well resume again. In this environment, we would expect sterling to hold its own against the dollar and give back more ground against the euro.

If we now turn our attention to the Swedish and Norwegian currencies, we will find that although they are driven by a range of similar forces, some are distinctly different. Both economies are relatively advanced, small and open, and are therefore subject to the fortunes of their major trading partners in Europe and the US.

Norway is a major oil exporter, and the markets often focus on swings in the oil price as a reason to buy or sell the krone. The sharp rise in oil prices in past months saw the Norwegian krone outperform the Swedish krona but this process has now reversed somewhat.

However, the operation of the Norwegian Petroleum Fund ensures that the influence of oil on the currency is very limited and the major driving force in the relationship between SEK and BOK is relative interest rates. These suggest that Sweden should outperform Norway over the next few months.

The similarities in the forces on both Sweden and Norway show both currencies appreciating against the dollar since early 2002 when the US dollar began its decline.

The differences in the forces of the currencies can be best seen by analysing the NOK-SEK cross rate.

The summer rally in NOK-SEK seems to have been driven by the surge in oil prices. However, while Norway is a major oil exporter, and oil revenues will rise because of the price move, the impact on the currency is very limited.

The workings of the Petroleum Fund ensure that increased oil revenues are automatically recycled into overseas assets. In fact six new management mandates were announced towards the end of summer for the fund, which now totals around US$140 billion. With oil dominating the markets, however, some investors seem to have bought NOK as a proxy for oil.

The large cuts in Norwegian interest rates in 2003 were associated with an equally large decline in the cross rate. In the early part of this year, there had been expectations that the Norges Bank would begin to unwind some of its easing moves as global growth picked up and oil prices kept on rising.

This saw interest rate swap spreads move back in favour of NOK and the cross move up from 1.03 to 1.12. However, underlying inflation in Norway has remained extremely low (partly because of the strength of the currency) and there is little prospect of the Norges Bank raising rates for some time to come. Current interest rate spreads would seem to be consistent with a lower cross.

Although the inflation differential almost completely closed in both Norway and Sweden early this year, it has widened again in recent months. Swedish underlying inflation has moved a little higher (as it has in several other countries) but Norwegian inflation has remained at 0.2% y-o-y compared with an inflation target of 2.5%.

In fact in its latest inflation report, the Norges Bank said it expects inflation still to be below target in the summer of 2007.

While lower oil prices will have no direct negative impact on the NOK, they may be enough to persuade holders of long NOK positions to unwind, and this could see the cross move back more in line with interest rate differentials.

Our economists would expect to see the Swedish krona outperform the Norwegian krone over the next few months as the Swedish economy continues to improve and as interest rates in Norway remain at record low levels.

This report has been compiled by HSBC Bank Malta plc on the basis of economic research carried out by HSBC International Bank's team of economists and financial experts.