The dollar controls the krone exchange rate Finansavisen

To capture a broader value of the krone exchange rate, I-44 is often used, the import-weighted krone exchange rate measured against the currencies of our 44 largest trading partners. Here, the eurozone accounts for about a third, followed by China and Sweden with both around 13 percent of the total. The US dollar accounts for only 7 percent of imports and I-44.

USD crushes EUR

Since the eurozone has a greater weight in I-44 than the US, many would perhaps have expected to see that the import-weighted krone exchange rate had followed the euro more closely than the dollar. The attached figure shows, however, that the krone exchange rate has moved much more in step with the USD than with the EUR when these are also measured at their respective trade-weighted rates, where the NOK has zero weight. A simple regression model in which the import-weighted krone exchange rate is explained either with the trade-weighted EUR or the trade-weighted USD shows that the USD explains as much as 77 per cent of the development in I-44 since 2004, while the EUR explains only 19 per cent. If we include both EUR and USD in the regression model, they together explain 83 per cent of the development.

Although the regressions here are simple, it is rare to find variables with such good explanatory power over time when it comes to currency. The conclusion is that the krone exchange rate has primarily become weaker because the dollar has become more valuable in recent years.

The interest rate effect

The dollar tends to strengthen broadly when the US economy is doing better than other major economies, as is the case now. But the dollar also tends to strengthen when the world economy is weak – such as during the corona pandemic – or when risk aversion is high, such as after Russia’s attack on Ukraine in 2022. The US dollar is a safe haven in uncertain times, and the last few years have thus much went the right way for the dollar.

A Norwegian policy rate of 4.5 per cent thus appears unattractive, and especially when we know that the krone exchange rate is significantly more exposed to risk than the dollar.

However, the USD does poorly when the economic outlook for the rest of the world is better than for the US economy, and when US interest rates are lower than other economies. That is not the case now. The policy rate in the US is 5.5 per cent, the same as in New Zealand, followed by the UK at 5.25 per cent and Canada at 5.0 per cent. A Norwegian policy rate of 4.5 per cent thus appears unattractive, and especially when we know that the krone exchange rate is significantly more exposed to risk than the dollar.

Fewer Fed cuts

However, the dollar weakened at the end of 2023, and the krone exchange rate gained a better footing. Norges Bank surprisingly raised interest rates in December last year, and announced that it would be kept unchanged for quite some time. The action stood in stark contrast to the communication from the US central bank, which signaled three interest rate cuts this year.

After three months of inflation figures that have been higher than expected, less than two interest rate cuts are now being priced in the US this year.

At the start of the year, interest rate market participants believed that the Fed was going to lower the key interest rate even more strongly, with expectations of six interest rate cuts this year starting in March. After three months of inflation figures that have been higher than expected, less than two interest rate cuts are now being priced in the US this year. The USD has thus strengthened again on a broad front, and the krone exchange rate has weakened sharply – despite the fact that oil prices and stock markets have risen so far this year.

Need help

It illustrates that in order for NOK to strengthen itself, we will probably have to get help from outside. The fact that the ECB will most likely start lowering the key interest rate gradually in June is positive for the krone, all other things being equal. But in order for the krone exchange rate to become significantly stronger, the key interest rate in the US will probably have to be lowered and the US dollar weakened.

The best outcome for the krone exchange rate is that lower inflation with our trading partners results in lower interest rates abroad, while international economic activity picks up and energy prices are high. We still believe that price growth abroad will moderate, although it will take time, and that the central banks abroad – including the Fed – will have room to gradually lower interest rates. That is the main reason why we still do not give up our belief in a slightly stronger krone eventually. Or a weaker dollar, because everything in the currency market is relative.

Dane Chekov

Senior strategist, Nordea Markets