The forint is on the march
Last October, the fall of the forint seemed almost unstoppable, and it quickly became apparent that the MNB had to do something if it did not want to risk a more serious exchange rate crisis. This happened, on October 14, Barnabás Virág appeared in a video from the annual general meeting of the International Monetary Fund (IMF) in Washington and announced that the Monetary Council had decided to increase the benchmark interest rate by 500 basis points and that it was ready to temporarily provide for the burden of foreign exchange reserves the currency needed to settle the energy bill, so that the actors do not have to exchange it on the market.
A week later, there were already signs that the big forint rescue operation was successful, as the Hungarian currency began to strengthen significantly. Then, referring to Mario Draghi’s speech in 2012, we stated that October 14th was “Hungary’s whatever it takes moment”, when the MNB had to demonstrate that it was ready to protect the Hungarian currency at any cost. Since then, the forint became the world’s best-performing currency in 2023, which means that the rescue operation was clearly successful.
At first, no one knew how long the extremely high 18 percent benchmark interest rate would last, in mid-October even Barnabás Virág made a half-sentence that they hoped it would only take a few days or weeks until the market calmed down. Since then, however, more than half a year has passed, and the Hungarian interest rate level has not changed for the time being, and now the possibility of a more serious relaxation at the next rate-setting meetings arose for the first time.
This gives an answer to what primarily drove the exchange rate of the HUF in the last six months. Of course, the sharp drop in energy prices on the world market also mattered a lot, which improved Hungary’s external financing position, but
it can be clearly stated that the huge interest rate difference is now the main support of the forint.
Development of the EUR/HUF exchange rate
The Hungarian interest rate is among the ten highest in the world
Because of the extremely high interest rate, the forint became one of the world’s favorite investments this year, and according to the news, even the biggest global players have noticed the potential of the Hungarian currency. A high interest rate difference means two things:
- On the one hand, it becomes very expensive to take positions against the given currency (shorting it), since the holding of the weakening position must be continuously financed at this high domestic interest rate. . In the case of the forint, this now means that a foreign investor investing in dollars or euros loses approximately one percent of his short position per month, which could only be compensated by a greater weakening of the forint. The MNB’s primary goal in October was to significantly increase the cost of taking such positions, thus deterring speculators.
- On the other hand, the reverse of this also works, you can make money on the huge interest rate difference, this is called a carry trade, when an investor takes a position specifically for this purpose.
Currently, the Hungarian reference interest rate is among the ten highest in the whole world, only countries such as Zimbabwe, Argentina or Ukraine are ahead of it. This means that one of the most attractive carry trade areas is currently the HUF.
Investors are typically looking for a currency that is relatively safe, there is no need to fear a major collapse or state bankruptcy, but the interest rate is noticeably higher than that of similar payment instruments. This is precisely why the forint can now be one of the market’s favorites, since as a member of the EU, they do not have to fear economic problems like collapse, moreover
nor do the fundamentals of the Hungarian economy justify mentioning it on the same page as Zimbabwe, Argentina or Turkey.
How exactly does a carry trade work?
As mentioned, the essence of carry trades is for investors to play the interest rate differential. In other words, they take a loan in a currency with a lower interest rate, then invest it in a currency with a higher interest rate, and the interest difference is booked as a profit. In general, this kind of capital moves quickly, so-called “hot money”,
this is the reason for the larger-than-average fluctuations of the forint recently.
In practice, the interest rate difference can be “gamed” in two ways:
- Through a foreign exchange swap, when a foreign investor does not specifically buy a Hungarian asset, he just swaps his currency and thus wins the interest difference. In this transaction, Hungarian commercial banks are typically on the other side, providing the HUF.
- It also happens that a foreign player not only enters the market through a swap, but also buys the specific Hungarian instrument, which has a high interest rate. Such an instrument can be, for example, a central bank discount bond or a discount treasury bill (the interest rate on longer-term government securities follows the benchmark interest rate less). Such so-called real money investors move more slowly, and rather consider the fundamentals in addition to the interest rate differential.
Which strategy each player uses depends on their investment policy. Typically, money market funds (hedge funds) want to make as much money as possible quickly, they usually pocket the interest difference through currency swaps, and when they feel that “the story is over”, they continue to stand. Longer-term, strategic investors, such as bond funds, on the other hand, also believe in the appreciation of the given asset, so they stay on the market longer.
Why is the carry trade so uncertain?
History shows that carry trade stories like this one have risks. Primarily when the given high-interest currency begins to weaken for some reason, even due to external reasons or a crisis situation. In this case, the exchange rate change can take away what the investors are looking for in the interest rate difference. And if such a position is taken en masse with, say, significant leverage, then this can also lead to a very quick escape. It is said that these stories often take months or years to build up, but they can explode in days or weeks.
Based on the principle of interest parity in economics, an unhedged carry trade cannot show a significant return for a long time, since the interest rate difference between two given currencies must always reflect the risk inherent in exchange rate movements. In other words, the interest rate of a given currency can be significantly higher precisely because, according to the market’s assessment, there is a high risk of weakening, and if this happens, then the money earned by carry goes there.
It is difficult to estimate exactly how much capital has moved next to the HUF in recent months due to the interest rate difference, but several figures indicate that it is a significant amount. Foreigners’ holdings of government securities rose to a historic high, but within this, holdings of HUF-denominated securities with maturities of more than one year jumped, meaning that most carry traders would rather be in swaps.
according to our market sources, in recent months it was clearly visible that several billion euros of capital began to play on the Hungarian interest rate differential.
“The money that came in will also go out” – Could this make the forint vulnerable?
The main topic of the next period may be how this Hungarian carry story ends, since this week the MNB also acknowledged that the issue of reducing the key interest rate will be on the agenda at the next meetings. For now, it is not clear whether this will start a process where investors start to close their positions, which would lead to a possible weakening of the forint.
It is certain that the capital that has flowed in in recent months will eventually go out
– said one of our market sources.
Of course, it would be premature to bury the forint for the time being, according to some experts, even the start of interest rate cuts will not bring about a turnaround, and may even trigger a final attack, as investors may try to take advantage of the Hungarian interest rate differential until the last moment. Moreover, even if the 18 percent rate starts to decrease, even then we will still have the highest interest rate in the region. If it closes with the base interest rate of 13 percent by the fall, as Barnabás Virág considers realistic, it will still be almost twice the Polish and Czech interest rates of around 7 percent. That is
it is unlikely that investors would run away.
In the longer term, the central bank should ensure that the bloated carry stock is gradually reduced in such a way that the fundamentals of the Hungarian economy improve, primarily its external financing position, and, if possible, an agreement is reached on the future of EU funds. After all, long-term, fundamental investors could appear who could trigger the eventual withdrawal of those who play on the interest rate difference in the short term.
Cover photo: Balazs Mohai/Bloomberg via Getty Images