• Time to buy SGB1041 in ASW spread.
• Heading down. Continuing pressure on rates likely in a troubled environment.
Trades
- New, buy SGB1041 in an ASW spread at -90bp. Profit/loss targets: -110bp/-80bp. Carry-0.8bp/m. An alternative is to buy SGB1041 versus 2Y EUR swap.
- Profit taken. Implied forward ASW spread sell SWH183 buy SWH185 against matching forward swap at 190bp, closed at +158bp. Profit: +32bp. Profit taken. Receive 1Y1Y SEK versus pay 1Y1Y EUR at +113bp, closed at +96bp.Profit +17bp.
SGB1041 In An ASW Attractive
In the past few months, the ASW in SGB1041 has tightened somewhat. This might appear odd in the current unstable environment but it has been driven primarily by tighter TED spreads. A quick glance at historical developments shows that TED spreads are (unsurprisingly) well correlated with the SGB1041 ASW. Where do we go from here?
As we see it, SGB1041 is a loan that should be in high demand. Stable AAA-rated government bonds are not exactly plentiful and when SGB1046 matures in October this year SGB1041 is set to become the shortest government bond (apart from SGB1055 where there is only SEK9.5bn outstanding). This should increase demand from money market funds.
The demand from money market funds is naturally affected by flows into the funds. We see a pattern where softer equity performance leads to more flows into money market funds. Hence, we expect continued demand for short government bonds from these funds as the stock market is struggling (see charts).
Moreover, as long as the acute crisis persists, foreign flows into the Swedish market should continue unabated. For investors that want to gain exposure to the currency, parking money in the shortest government bond is attractive. Moreover, under continued market tension, near convergence between Swedish and German government bond rates should gradually occur.
Surprisingly, SGB1041 has not been particularly well demanded in the repo market and has traded as GC. We see a strong likelihood that it could once again start to trade special, especially if more foreign accounts enter the Swedish market. These investors often want the currency exposure and thus have no interest in participating in the repo market. SGB1041 has previously traded up to 20bp expensive in the repo market compared with the Riksbank repo rate and we have no difficulty seeing SGB1041 moving towards these levels. This should directly affect the yield level in SGB1041.
It is also noteworthy that the 2Y-10Y curve has flattened significantly and trades close to previous range lows. We would not be surprised if more investors started entering curve steepeners. This would drain SGB1041 from the market, either in the form of cash bonds or indirectly through futures positions. Interestingly, the open interest in the 2Y is close to a multi-year low, indicating that market positioning in the 2Y segment is fairly small at the moment, which explains why SGB1041 has not been particularly demanded. 
Regarding TED spreads, even though we have no strong view in the short run, we believe fixings could be under upward pressure as we near the June IMM date. Cash tends to get more expensive around the IMM date and three covered bonds mature in June, with a significant amount of coupon payments due (around SEK60-70bn in total at the time of writing). Swedish fixings should definitely be affected if Euribor fixings fail to fall further, as has been the tendency over the last few days. 
We recommend buying SGB1041 in an ASW at -91bp. Profit/loss target: -110/-80bp. Carry is slightly negative, around -0.8bp/month.
An alternative with more potential, and more risky, is to buy SGB1041 versus EUR swap instead. We believe in a gradual convergence in bond yield terms along the whole curve, at least in that direction – not necessarily in terms of the actual policy rate. In addition, the risk and uncertainties in the European banking system is mounting and might at some point move Euribor fixing up. The big uncertainty with such a strategy is whether the ECB and/or other central banks add more stimuli, i.e. more/cheaper liquidity. The question is how bad it can become before that happens.
Heading DownMost things, with the exception of the yield level being historically low, suggest that rates are likely to continue to move lower in the near-term. Currently, there is not much to suggest a sell-off. We believe that Swedish government and mortgage bonds are attractive from an international perspective as long as the foreign debt problem lingers on and the global business cycle shows signs of weakness.
The Swedish agenda is short on data in the coming week but several Riksbank Board
members will speak on the outlook for the Swedish economy. It is hoped they will give
clues on how they view the accelerating debt crisis in EMU. Even though they have had a
pretty harsh stance about the impact of European debt problems on the Swedish economy,
it would be surprising if they were not increasingly worried.
It is clear that financial market worries have escalated since the election results in Greece and France. The Greek election shows that a large portion of the Greek population takes a rather inconsequential approach to EMU membership and the austerity packages: they want to remain in the euro but at the same time they do not accept the austerity packages. Either Greek politicians have not explained clearly enough how this fits together, that you cannot have your cake and eat it, or they simply hope that the EU/ECB/IMF will continue to lend money, although Greece does not fulfill the requirements.Opinion polls are volatile but you cannot exclude the possibility that the anti-austerity parties with Syriza at the front will have a majority in the re-election on 17 June. If so, Greece would probably
have to leave the euro. Since the consequences of this for both Greece and other EMU countries are quite uncertain, recent market reactions seem quite understandable.
Moreover, the new French president François Hollande’s idea that there needs to be more emphasis on growth-oriented measures and less austerity is clearly attractive for people that have been hit by the current rough times. From an investor’s perspective, however, it means that many of the countries that have signed up to the new growth and stability pact, the so-called "fiscal compact," now risk deviating from their respective budget consolidations programs. That would hardly be seen as positive and uncertainty, arguably, has increased also in this respect.
The downgrade of Italian and Spanish banks recently and rising cross-country yield spreads do not improve the situation. It is becoming all the more uncertain whether the "fire walls" erected last year (the European Financial Stability Facility, European Stability Mechanism and possibly IMF money) are sufficient, as the cracks in the system appear to be widening and funding costs are again surging. In addition, it appears that the imbalances in the EMU’s payment system are continuing to grow: Target2 statistics reveal that the Bundesbank’s credit to other central banks (mainly Italy and Spain) amounts to more than EUR600bn, i.e. more than the ESM has at its disposal.
A more recent feature in the global economic picture is somewhat more shaky data from the USA. For instance, the US surprise index is slowly heading lower and is now starting to approach strained, although not alarming, levels. The US labour market has not been convincing lately and, hence, there is gradual uncertainty concerning the stability of growth prospects. This week there were also indications that US manufacturing is facing headwinds (other parts of the world have shown PMI manufacturing at 50 or below). The regional index from Philly Fed unexpectedly fell to -5.8, raising concerns that ISM manufacturing may show weakness too. Needless to say, a weakening US economy in parallel with the European debt turmoil risks increasing volatility in financial markets.
Is there nothing positive to say then? We are sorry but at the time of writing it is hard to see what that would be.
Disclosure
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The authors of this research report are Marcus Söderberg, Strategy/Quant Analyst, and Michael Grahn, Strategy/Macro Analyst.
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