Bull Flattening Next - Either In Covered Bonds Or In Govies‏

The 2s10s curve (both government bonds and swaps) has steepened by some 30bp in the past month and is now trading not far from range highs. The current pricing in the Riksbank is a cut of about 17bp over the next two meetings, a reasonable figure in our view, judging from data we have received so far. What is unusual is how short-end yields have decoupled from the long end.

As both the ECB and the Riksbank have an easing bias, we are sceptical that the long end of the yield curves could continue to sell off for a prolonged period. Eurozone growth is still weak and further monetary stimulus is warranted. Despite the fact that correlation has decreased somewhat lately, we still see German long rates as one of the most important factors for the Swedish long end. The mere threat of negative deposit rates is likely to help to keep long-end core rates at high levels, even though there are practical problems in implementing it.

10Y Swedish government bonds have underperformed European bond markets recently, which might persuade foreign end-investors to shift to Swedish long government debt again. Also, the upcoming very large index extensions in June should lend support to the Swedish long end and trigger extensions along the mortgage curve.

Also, a formal proposition for a Solvency 2 based discount curve for L&Ps has now been presented and as expected the 10-year point will be the last liquid point along the swap-based curve. After an initial underperformance when ultra long bonds were sold this ought to be supportive for the 10-year segment in Sweden, as hedging flows should be concentrated in this segment.

Moreover, macro-wise there is some evidence that our preliminary first quarter GDP forecast (1.5% y/y) will have to be scaled back half a percentage point or so. A softer GDP figure could be supportive of the longer end given the fact that SGB1049 trades relatively close to earlier lows.

In mortgage bonds, longer maturities could benefit from the continued hunt for yield. Also, as we have pointed out earlier, real money investors seem to be significantly underweight in the longer mortgage bond maturities. The index extension is thus likely to trigger extension flows, see Strategy: Expect more performance in covered bonds despite risk, 21 May.

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