Index-Linked Report: Tap Auction SGBi3108‏ Bond

On Thursday the National Debt Office will tap SEK1bn of the SGBi3108 bond (2022-06- 01) in the first linker auction since the summer break; the last one was in middle of May. We have seen a significant shift in demand for linkers over the summer amid more and more evidence that the trough in the inflation rate cycle is behind. As we predicted at the beginning of the summer, interest (and demand) for linkers increases as inflation gradually moves higher. Despite the performance in the summer, linkers still offer good value and thus we expect good demand in the tap auction on Thursday, although we believe shorter linkers offer even better value.

We have seen a considerable repricing of Swedish inflation over the summer. Nevertheless, we still regard current pricing in shorter BEI rates as attractive. We suggested buying SGBi3107(2017-06-01) in a BEI rate in mid-June, when it traded at 112bp. The rate is now at 144bp, up roughly 30bp. Looking at the forward BEI rate curve, reveals that forward BEIs, like 5Y5Y, are now trading close to 2%, whereas the shorter BEIs and the shortest forward BEI rate, Dec 2015 to Jun 2017 (SGBi3105 to SGBi3107), are below 1.5%. Hence, inflation expectations over the next four to five years are still low. Another way to illustrate the cheapness of the shortest bonds is to calculate the forward BEI rate given our inflation forecast up to summer 2015 and the current pricing of BEI SGBi3107. Assuming our forecast up to June 2015 is correct, then the average inflation rate between 2015 and 2017 needs to be below 0.8% in order to justify the current pricing of BEI 3107.

So what about our inflation forecast over the next couple of years? We do not make any strong bets on rising commodity prices or anything like that; rather the gradual rise in inflation over the next six to nine months is likely to be driven primarily by base effects from earlier rate cuts. However, this will generate an inflation compensation, which is equal to a nominal yield in, for instance, SGBi3105 equal to 1.90% over the next six months, which should be compared with the yield of the nominal comparator, SGB1049, at 1.20%.

So, there is no need for a bearish view on inflation – we believe base effects will do much of the job, at least over the next six months or so. Apart from interest rate costs, there is an additional potential base effect that might affect inflation in Sweden in the autumn and winter season, which is the currency. The effect of the strong krona last summer will gradually ‘disappear’ from the inflation rate and possibly affect inflation (not in our base scenario). This might prove very important. Why? Take a look at the chart overleaf. Imported inflation (goods and services) is running close to -2%, thus holding headline inflation down. Even more interesting is that domestic inflation is running at a two-year high above 2%. Amid signs that suggest that the imported disinflation is about to abate somewhat (the last observations in the chart) due to base effects from the currency (but perhaps also from commodity prices), the risk of a faster rebound in Swedish inflation is mounting. Added to this tension is rising in the Middle East, pushing oil prices higher, electricity prices are higher in Sweden and consumer confidence is inching higher for every month.

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