Ahead In The Riksbank: First Rate High Expected In Late 2014

Receive SEK FRA By June 14 at 1.30%. P/L: 1.20%/1.bp/190bp. Roll down: +6.5bp/3m.

Protect positions for a soft Riksbank:

On Monday, we recommended receiving SEK 5Y5Y and paying SEK 1Y1Y in a risk neutral spread (see Trade Recommendation: Receive SEK 5Y5Y vs pay SEK 1Y1Y, 21 October). This position has started well but ahead of the Riksbank meeting tomorrow, we suggest hedging the position by selling the FRAJUN14 contract (receive) at 1.31%. This would protect the position from a soft Riksbank, which could potentially cut back on rate hikes and send the 1Y1Y rate lower. Admittedly, it is possible that the market will gradually move towards assigning a certain probability of a rate cut in December or early next year. Moving out one further step to FRA September 14 would give an additional 11.5bp compared with the June contract. However, the uncertainty increases significantly as we move further out on the FRA curve. The Riksbank itself currently expects the first rate hike to occur in late 2014. Thus, we are more comfortable taking position in the June 14 contract in a larger nominal amount to offset the lower volatility.

Moreover, we expect TED spreads to remain well behaved, as liquidity is ample in the Swedish money market. Hence, the upward sloping TED spread curve (FRA versus RIBA contracts).

Alternative trades and risks
In Trade Recommendation: Receive SEK 5Y5Y vs pay SEK 1Y1Y, published on Monday, we suggested hedging the 5Y5Y versus 1Y1Y by receiving 9M 3M forward. This also diminished the negative roll of the initial position.

As we have shown earlier, bond spreads to Germany are driven largely by relative monetary policy outlook. Hence, a soft Riksbank would tighten spreads along the whole yield curve. This looks interesting as spreads are still elevated, in a historical context, and the recent divergence in surprise indices and yield spreads is stretched (see chart overleaf).

The risk of a hawkish Riksbank is small in our view and should be offset by paying in the 1Y1Y in the 5Y5Y versus 1Y1Y trade. If the trade is done outright, the risk is greater. The trade pay 1Y1Y and receive 1Y is also an alternative trade.

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