By Krisztina Than and Gergely Szakacs
BUDAPEST, Sept 24 (Reuters) - The Hungarian central bank's move to lower its inflation target has sent a fresh signal to investors that the new government in Budapest is sticking to its goal of adopting the euro, boosting appetite for local bonds which have outperformed Polish and Romanian peers.
The National Bank of Hungary on Tuesday lowered its inflation target to 2.5% from 3% effective from 2028, which it said should anchor inflation at lower levels and "supports
meeting the requirements for euro adoption."
Hungary's benchmark bonds have been the darling of foreign investors in Central and Eastern Europe this year, especially since Peter Magyar's centre-right government ended nationalist Viktor Orban's 16-year rule.
The 10-year bond now trades at a yield of 5.64%, below Poland's 6.16% and Romania's 7.29% as foreigners' holdings of forint-denominated bonds have surged to their highest levels since 2019.
Deutsche Bank said overseas investors poured $13.5 billion into the local bond market in the year-to-date, including $10 billion after Magyar's April election victory, representing what it called the largest annual inflow by a wide margin.
"While dedicated investors are already heavily overweight HUF local bonds (5 out of 5) ... non-dedicated investors have yet to participate to the same extent," it said in an emailed reply to Reuters.
"If that begins to change, and we are convinced it will post inflation target change, EU funds allocation and the announcement of the budget for 2027, Hungary could see a further meaningful wave of foreign inflows."
The debt agency AKK told Reuters that by the end of August, the share of foreign holdings in local bonds had risen to 34%.
DEFICIT REDUCTION PLAN A CRITICAL FACTOR
Analysts and fund managers said there was room for yields to fall further provided Hungary delivers on its deficit reduction plans, €16 billion of European Union funds unfrozen by Brussels arrive and tensions in the Middle East ease, reducing global risks.
ING analyst Peter Virovacz said the lower inflation target supports the long end of the bond curve, and the forint, which has firmed 6% against the euro this year, should benefit from the central bank's decision to pause rate cuts.
"In the short term, there are the energy price risks... but a credible euro adoption story and the inflation target drives yields lower on 10-year, 15-year, 20-year and even longer maturities," said Virovacz, who projects the 10-year benchmark yield could drop to 4.9% by the end of the year.
Hungary could enter ERM-2, the waiting room of the euro, in 2029 or 2030 and adopt the common currency in 2032, based on a Reuters survey of economists this week. The government has yet to set a target date for either.
BETTING ON THE EURO
The main bet is that Hungary's relationship with the EU — fraught with conflict under Orban — is changing, said Recai Gunesdogdu, Head of Portfolio/Investment Management at Nomura Asset Management Europe.
He added that at the heart of the convergence trade was the long-term prospect for integration into the euro area.
"The long end also stands to benefit disproportionately if the new government delivers on fiscal consolidation, as an improving fiscal trajectory would compress the term premium in longer-dated HGBs," he said. "Hungary was one of our top emerging market picks heading into the election. We have maintained an overweight duration position and reinstated our forint overweight in June."
Investors will be closely watching the government's 2027 budget and medium-term fiscal plan, due to be unveiled next month, to see how it would cut the deficit towards the 3% level required to join the euro. With the gap projected at 7.5% of economic output this year, it's a tough challenge.
"There is quite a lot of positive sentiment in the market already, any disappointment on policy delivery could lead to a swift repricing," Gunesdogdu added.
The fact that long-dated Hungarian bond yields now trade below those of A-rated Poland is a notable indication of the market's confidence in the new policy direction, said Viktor Szabo, an EM debt portfolio manager at Aberdeen.
James Ringer, Global Fixed Income Fund Manager at Schroders, said they had been overweight hard currency Hungarian bonds for some time now, predating the April election.
"The election outcome increased our conviction, and so we have added to the existing hard currency position, as well as some local currency versus Germany as a convergence play," he said. "The path (to the euro) will be bumpy, as progress needs to be made on many fronts, but the intent is clear."
(Writing by Krisztina Than; Editing by Toby Chopra)
