Speculators smell blood as Danish peg comes under fire
After the shock removal of the Swiss peg to the euro, speculators are testing the DKK peg, though, for now, the central bank is well-placed to withstand the pressure.
As the dust settles following the carnage of the broken CHF peg, traders have turned their attention to the other European G10 currency peg, that of the Danish krone, an established part of the FX landscape that has endured more than 30 years.
During the euro crisis of 2010 to 2012, DNB spent more than DKK270 billion defending the peg. While pressure on the peg has escalated in recent weeks, it is difficult to quantify. There are no sufficiently timely measures of currency turnover by which speculation can be accurately measured, or futures linked to DKK which would illustrate the situation for more liquid currencies.
However, implied volatility in EUR/DKK has spiked since the Swiss National Bank (SNB) abandoned its own de facto peg, demonstrating some level of pressure build-up.
EUR/DKK implied volatility
The Danish krone is held on a particularly tight leash, relative to most global currency pegs, with a mere 2.5% band either side of the rate of DKK7.4 per euro. This is a much smaller band than is mandated by the exchange rate mechanism, under which the peg was originally implemented in 1982.
The pressure being exerted on the DKK peg today resembles that being exerted on CHF before its peg broke, in that in both cases market forces are trying to push the pegged currency up against the euro.
This is an important distinction because in theory a central bank has infinite ammunition available to prevent currency appreciation, given it can print local currency and sell it, accumulating more and more foreign currency reserves. Conversely, its ability to prevent currency weakness is limited by the foreign currency reserves it holds.
However, there is an equally striking difference between the CHF and DKK pegs.
Adam Cole, head of G10 FX strategy at RBC, says: “The pressure on CHF was created by genuine safe-haven capital flows, as money was repatriated from places like Russia and Greece into Switzerland. Those were flows the SNB decided were likely to persist and possibly even intensify over time, which pushed it into the decision it made.
"In Denmark, things are different. The flows are more short term, more speculative. This isn't about asset reallocation – this is about testing the central bank's resolve.”
There are practical limits to a central bank's ability to amass foreign currency reserves. If a central bank keeps buying a currency that is depreciating, in this case euros, it risks losing money in the long run if it is ultimately forced to unwind its position.
Steen Jakobsen, CIO at Saxo Bank in Copenhagen, says: “For the central bankers it’s a time issue – they feel they can do this longer than the market has time or patience for.”
Others agree that the DNB is well-equipped to withstand the speculative pressure.
RBC's Cole says: “If Denmark was able to hold the line in 2012, when the peg was under very considerable pressure, we think it will hold this time too. This bout of pressure will be short-lived, because we think the pressure on the euro will be relatively short-lived.”
By the second half of the year, there should be at least a moderate cyclical recovery in eurozone activity that should help EUR recover, he adds.
However, the possibility of an escalation of the pressure proving too much for DNB cannot be discounted.
Saxo's Jakobsen says: “Should we see a Grexit and/or Brexit, we would expect more pressure on the DKK. Foreign reserves are less than 30% of the balance sheet at present, but could increase to unacceptable levels of 80% to 100% of GDP. The fight is basically: time versus size of balance sheet of the DNB.”
The krone will not be the only currency under pressure in such circumstances, and if the outlook for the euro deteriorates further and persists for months it will be the emerging-market countries such as the Czech Republic – which followed Switzerland into a peg regime which will be under the severest scrutiny.
For the G10 central banks, the recent decisions of the SNB and the Central Bank of Russia to abandon their pegs could conceivably alter the calculation about the integrity of pegs and firepower to break the backs of speculators. The alternative course of action – during episodes of extreme FX pressure and without a pegging policy – would be a hit-and-run intervention policy, a form of sporadic intervention that typically denies traders the opportunity to trade ahead of them.
That possibility is clearly not being discounted by investors.
James Wood-Collins, CEO at Record Currency Management, says: “Some clients did not see the point in putting on currency hedges for certain pairs, such as EUR/CHF, as they felt the SNB was doing the work for them. But now there is a lot more interest in putting on hedges for pairs, even if there is a peg in place, such as EUR/DKK.”
If the peg did break, the implications would be far more localized than in the case of Switzerland. It would be bad news for the Danish economy, which would see its exports become less competitive with its principal trading partner: Europe.
Jakobsen says: “If push comes to shove, Denmark would rather join the EUR than allow a 10% revaluation. The reason for has multiple explanations, but the simplest one is the size of the Danish financial system. The pension sector on its own is 160% of GDP rising to 200% in the next 20 years. The liabilities are in DKK, but most assets are in EUR. The yield curve is in EUR. Elementary Dr Watson.”
Even so, it is still likely to be a matter of greater concern to Danes than international investors. Where many traders held CHF short positions that funded purchases in higher-yielding currencies, the DKK is not a funding currency for global carry trades.
While most analysts reckon the DKK peg will withstand the eurozone crisis, risks have risen post-SNB, justifying the low-cost punts against it.