Riksbank in wait-and-see mode.
Long dated ASW spreads could be under tightening pressure but entry levels are unattractive.
Risk on sell SEK but it is beginning to look stretched.
Trades
Profit taken, sell SGB1056 (June 2032) versus SGB1057 (November 2023) in a tail versus matching swaps. Profit: 3.5bp.
Riksbank in wait-and-see mode
We are in a rather confusing situation. Fixed income markets seem to be increasingly convinced that Europe is heading towards recession and rates are going down. At the same time, equity markets show a significant upward correction. Credit spreads widened along with falling equity prices late last year but are now tightening again. The SEK typically trades weaker when equity prices are down and vice versa. That correlation appears to have reversed of late.
After the January board meeting, ECB president Draghi explained that the board was in assessment rather than decision mode. We take that as a sign that any alteration of policy guidance will rely on the ECB’s assessment of the medium-term outlook for growth and inflation as expressed in the new staff forecast.
Our guess is that the Riksbank is in a similar position, except the Riksbank presents updated forecasts at each policy announcement. As a minimum, we would argue that the Riksbank would acknowledge that growth risk has intensified both internationally and in Sweden. Having said that, one should remember that the Riksbank has already made rather significant downward revisions to the 2019-20 GDP forecasts and compared with private banks’ forecasts the current Riksbank projection does not really stand out in a meaningful way. Therefore, at this stage we think that the most likely outcome is more emphasis on downside risk but no changes to the rate path. That would allow the Riksbank to wait for the outcome of Q4 GDP and more information about the ECB’s updated view on the EZoutlook and possible policy implications.
In the meantime, recent German order data showed a y/y drop of no less than 7%. It does not appear to be the car industry and its issues with new emission tests that is creating problems, as orders for cars and part have recovered of late. Instead, other industries are in reverse. Admittedly, we have some trouble grasping what is going on in Germany.
However, considering the strong correlation between Swedish and German manufacturing it is a little worrying. Our base view is that while the global (and Swedish) economy are slowing, fixed income markets are too gloomy and we see some correction in long-term yields as warranted. However, more data of the kind we got from Germany would not help the case.
At the same time, the current environment is positive for covered bonds, considering the steepness of the curve, the yield pick-up covered bonds offer versus govvies and from a carry and roll-down perspective. From a repo-financed investor’s point of view, the total ASW carry+roll down profile is quite flat between 2021 and 2024 maturities (see chart) for instance buying SHYP1585 ASW. Long dated ASW spreads could be under tightening pressure
but entry levels are unattractive
Fundamentally, we see clear supply-related factors that could affect longer ASW spreads. As we wrote earlier, we think the Riksbank is unlikely to extend QE beyond June 2019. In addition, we see upside risks to the latest SNDO forecast. So far, the accumulated deviation relative to the forecast is some SEK15bn and the SNDO probably needs to revise its growth assumptions (next forecast is due on 20 February).
For quite a while (mid 2018) we have been short the SGB1057 (Nov 2023) versus SGB1056 (June 2032) tail versus swaps. We reasoned that the very long end (>10Y) traded expensive given that the loans are not particularly dear in the repo market and would likely suffer from the introduction of SGB1061. The position has yielded a tiny 3.5bp profit but we acknowledge that the pricing has been slow to materialise and thus we close the trade.
Fundamentally, it could be argued that the Swedish long-end ASW spread should gradually move tighter as spreads are significantly wider than where the bonds trade in the repo market, given the possible turnaround in the supply balance. However, given the very reduced free float (no bond even reaches as little as SEK30bn in the 10Y segment), we think that it will take a long time for this repricing to occur.
In the meantime, the relative pricing versus Bunds looks clearly less attractive. Swedish long-end ASW spreads have cheapened steadily versus Bunds. Since May 2018, the ASW box has moved by around SEK15bp. Thus, we feel that entry levels are currently not attractive enough and decide to remain on the sidelines for now.
Risk on sell SEK but it is beginning to look stretched
Not much has gone the SEK’s way at the start of this year. We have already pointed at surprisingly weak macro data and revised growth assessments (IMF, Fed, ECB and other analysts as well as the Riksbank in December) with lower expectations regarding both the global and the Swedish economy. We ought to also mention the Fed’s and ECB’s signalling, or confirmation, of slower rate hikes from now on, where Draghi refers to weaker domestic conditions whilst Powell is mainly concerned with global risks. The Fed’s softer stance has mostly to do with factors that – maybe even to a higher extent – one could argue should be hampering Europe, the ECB and the Riksbank as well. With this in mind, we are not surprised to see EUR/USD trading lower and USD/SEK higher following the Fed’s unexpected U-turn: if the Fed turns dovish because of global risks, this should not be interpreted as a step towards policy-convergence where the Riksbank and ECB carry on as if nothing has happened. On the contrary.
Another observation is that the SEK since some time is acting more like a funding currency. Since last fall, we have seen EUR/SEK and USD/SEK disconnect from ‘normal’ stock market correlations. The typical pattern has been to buy SEK with rising stock markets and the other way around. This pattern now seems reversed. One possible interpretation is that investors largely use the SEK as funding for carry trades. USD/SEK is one obvious winner of this, NOK/SEK another. It is quite remarkable that this happens despite the Riksbank’s rate hike in December. However, Ingves’s careful, dovish, baby step has done nothing to reduce the rate gaps towards the Fed or Norges Bank. Possible rebalancing flows, e.g. when the stock market rises, might then make a smaller impact in the market.
Since the turn of the year, implicit volatility in the currency market has generally all but vanished. This might seem odd considering the global event risks, trade war, uncertain economic outlook and central banks that cannot decide whether the next move will be a hike or a cut. Nonetheless, this reflects an equally depressed realised volatility. If actual movements are small, one tends to believe that future movements will be small as well. At least until ‘something’ happens, a trigger. Furthermore, the stock markets have rebounded and Powell has signalled that the Fed does not want to cause the markets to enter ‘recessionmode’ if this can be avoided. The extremely low implicit volatility offers the best conditions for such positions. As we have said, implicit volatility is generally depressed in FX markets, where for example NOK/SEK (implicit 3M (NYSE:MMM)) is trading at the lowest levels since the mid- 00s. For example, 3M implied volatility in NOK/SEK is 5%, which implies an expected daily movement of about +/- 30 pips. For EUR/SEK, corresponding expected movement is +/- 3.5 figures. Almost nothing! In other words, it is ‘cheap’ to buy volatility (puts, calls, straddles). On this theme, we have recommended 3M straddles in EUR/SEK. We remain long NOK/SEK (from 1.0570).
We believe that surprisingly weak macro data, a re-evaluated view on the cyclical outlook and carry trades to a high extent can explain the sell-off in the SEK, i.e. if there is carry, there is a clear risk that this will continue. However, we feel that the recent rally in EUR/SEK has gone far enough. The Swedish surprise index is at historical lows and thus it should be easier to match or exceed expectations. Our (simple) model based on relative rates indicates that the spot is currently trading two standard deviations above ‘fair value’. As the SEK has collapsed, the rate spread has remained stable, indicating that EUR/SEK has overreacted. ‘Fair value’ is in the neighbourhood of 10.25 to 10.30, where we also find Fibonacci retracement levels of 50% and 61.8%, respectively. RSI is at 76, which indicates that the cross is overbought from a technical point of view, and thus ready to recoil.
Next week’s rate decision from the Riksbank is on top of the agenda for the SEK. As we have already discussed in this publication, we see no significant revisions for this meeting, even though the board might choose to express higher uncertainty regarding the global economy (could be SEK negative). At the same time, market pricing on the Riksbank is soft whilst KIX is approximately 5% above its Q1 forecast. One thing worth looking out for is that the mandate for FX interventions expires. This could be removed and it would not be unreasonable to do so in our view. If so, we might see some positive response from the SEK. However, can the Riksbank stomach this? The options market does not expect this to be a big deal, just slightly more volatile than a normal day: approximately 50% largerintraday movement than what is normal, corresponding to about five figures up or down. Even if the Riksbank does not make any major adjustments, we still feel this is low.
