The chart above shows, how the relationship between USD/NOK and 2-year yield spread has unfolded since 2012.

• It can be seen that the pair and the yield spread between 2-year treasury and 2-year Danish government bond have enjoyed a very close relationship.
• The Norges Bank (NB) began reducing interest rates in the aftermath of the ‘Great Recession’ of 2008/09. The interest rates declined steadily from 575 basis points in 2008 to just 125 basis points in 2009.
• The lending rates were gradually increased to 200 basis points in 2010 as the impact of the ‘Great Recession’ was less severe and the price of oil recovered. It rose further to 225 basis points in 2011.
• However, the interest rates were reduced again in the aftermath of Eurozone debt crisis. Since the end 2011, DNB reduced rates from 225 basis points to just 152 basis points in 2012 and was further lowered in the aftermath of oil price crash in 2014 to just 50 basis points and it remained at the level.
• It can be seen from the chart as while DNB started reducing rates in 2011 and in 2015 and maintained dovish tone, and the US Federal reserve indicated and began to wind up its asset purchases, the 2-year yield spread widened in favor of the dollar by more than 200 basis points and the exchange rate declined from 5.5 per dollar to 8.9 per dollar.
• However, since the beginning of this year, there have been speculations in the market that the Norges Bank (DNB) would soon follow other central banks in the region, namely the Czech National Bank (CNB) that increased interest rates by 20 basis points. However, the speculation remains capped by falling inflation rate that declined to 1.5 percent in August and a lower oil price.
• Still, a strong divergence is visible even with the naked eye. So far this year, the yield spread has widened by almost 18 basis points in favor of the dollar, while Danish Krone has strengthened by more than 600 pips.
• So, the exchange rate has moved much faster than the spread, which is not an unnatural phenomenon. However, such divergence will not sustain in the medium term.

Hence, we expect hawkish commentaries from NB, in absence of which the exchange rate could decline favoring the dollar. The spread is currently at 71 basis points and the exchange rate is at 7.9 per dollar.

With central banks changing their monetary policy outlooks, we highly recommend regular following of the yield spread.

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