CEE MONEY-Hungary c.bank faces tough call to avoid a rate cut too far
* Forward rate agreements have almost priced out further rate cuts
* Global worries over Fed stimulus weakened forint, bonds
* Bank needs clear exit plan from easing to avoid market setback
BUDAPEST, June 12 (Reuters) - Hungary's central bank faces ever-riskier judgments as its rate-cutting policy to back the government runs up against growing investor fears that could prompt a flight from the forint.
Markets have largely priced out more Hungarian monetary easing due to a global retreat from emerging assets - an unwelcome development for a government facing elections next year and needing low borrowing costs to cope with huge debts.
The bank's new management under Governor Gyorgy Matolcsy faces his most difficult test yet as a tide of cheap money that has helped the bank cut rates steadily without damaging the forint may now be flowing out.
Worried that the U.S. Federal Reserve may reduce monetary stimulus, investors have started to sell riskier high-yielding assets, knocking down the forint to 6-week lows to the euro this week and Hungarian bonds to the lowest since March.
A telling sign is that forward rate agreements, which three weeks ago still priced in a bottom of rate cuts at 3.25 percent, compared with the current 4.5 percent, almost fully priced out these reductions.
That should signal to Matolcsy, a close ally of Prime Minister Viktor Orban, that the bank will soon have to consider pausing or even ending its 10-month easing cycle or risk triggering a sell-off if it cuts Hungary's premium too much.
"Whether we have reached that level (in interest rates) is very doubtful for the time being. This is a risk at this stage," said Raiffeisen analyst Adam Keszeg. "(A selloff) usually comes like the floods when a dyke bursts."
Unorthodox measures like Europe's biggest bank tax have helped Hungary to stabilise its budget deficit and debt and cut inflation, but conflicts with Brussels over policy are fuelling investor worries.
Sharp forint falls could force the central bank to reverse some of its previous cuts, something Matolcsy surely wants to avoid with the economy barely clambering out of recession.
But the bank could find it hard to resist temptation to ease more, especially since the government is counting on lower rates to reduce its huge debt service costs, which could also create room to spend more in the budget ahead of elections next year.
A rapid outflow from bonds would make debt servicing more expensive, while a sliding forint could hit households still saddled with foreign currency debt. Compared to that, the benefit of further rate cuts could be small, economists said.
"It is inherently bad if they want to go to (rate) levels allowed by the market," said MKB analyst Zsolt Kondrat. "Because the market is trying to figure out how far the bank is willing to go, they could lead each other into the ravine."
Citigroup analyst Eszter Gargyan said the bank could cut rates once again by 25 basis points in June if the forint does not fall much further, and could signal a possible halt in cuts.
The bank declined to be interviewed for this article.
Even if selling pressure in forint markets abates, the bank must communicate to investors its strategy for ending the easing cycle to ensure a soft landing and prevent a sell-off.
"They need to signal how they imagine the end of rate cuts, and the worsened global environment provides them with a good opportunity," said Gergely Szabo Forian, analyst at Pioneer Fund Management. "So far it has been an easy ride, but of course in a fragile environment it is easy to make mistakes."
A slump of the Polish zloty last week was a clear example of the challenges central banks face when investors already pulling back from riskier assets are not sure when policymakers will stop reducing a country's rate premium.
Polish officials intervened in the market to reverse a 2 percent slide in the zloty to a one-year low after it cut rates and sent contradictory comments about rates and the currency.
"It is a warning sign that they were forced to intervene... just after the Monetary Council discussed easing," said Gargyan at Citigroup.
The Hungarian bank has given no signals yet about a possible change to its steady 25 basis point monthly rate cuts, and it has rarely intervened in the forint market in the past.
Matolcsy has only said so far that the cuts should take the base rate to a "neutral" level recognised by financial markets.
COMMUNICATION IN FOCUS
History should also make rate setters cautious, as the National Bank of Hungary has twice before hiked interest rates by 300 basis points in one step to stem market falls over the past decade - the last time in October 2008.
Most of the bank's current rate setters, who have all been picked by the ruling party or Orban himself, have not seen a market meltdown from up close.
"Sooner or later they have to start to communicate about that (end of cuts)," MKB's Kondrat said. "You have to do it well, and they have no practice. But they have the bank's staff to give advice."
The staff may be a sore point, however, as several of its key economists were sacked or have quit under Matolcsy who has introduced sweeping changes in the bank's management.
While analysts believe the staff still has the expertise needed, several sources who wanted to remain unnamed have told Reuters that communication between the bank's top leaders and its experts has become less efficient.
They said only a small group had insight on key policy decisions now and Matolcsy was very difficult to access after he implemented a top-down approach at the bank.
"I had no means to point out risks," one economist told Reuters as an explanation for why he left the bank.
Another economist who has also quit said: "The governor is now at the end of a very long chain ... I saw him only once, at the staff meeting, and even then only from a distance."
($1 = 226.9127 Hungarian forints)
(Additional reporting by Krisztina Than; editing by Stephen Nisbet)