ECB: risk down.
- How will the Riksbank respond?
- Relative flattening trend takes a break – curves could steepen in coming months.
- Current risk sentiment affects FX markets.
Trades
New, Steepen 3Y/10Y on the SEK swap curve. Start: 86bp. P/L: 105/70bp.
Profit taken, Relative flattener 2Y-10Y 1Y forward against EUR. Profit 4bp.
Profit taken, Outright flattener 2Y-10Y 1Y forward. Profit 13bp.
ECB: risk down
The ECB has been quite reluctant to accept the narrative that weaker growth data in the eurozone could be ‘for real’. When the Q1 18 GDP number was reported at 0.4% q/q, down from 0.7% in the previous four quarters, it was said to be a temporary dip. Q2 GDP also came in at 0.4% q/q. This was described as a natural alignment to potential growth. Q3 GDP rose by a meagre 0.2%. At the December ECB board meeting, Chair Mario Draghi acknowledged that growth had turned out weaker than expected. However, the balance of risks was still regarded to be broadly balanced – but moving towards the downside. Recent data do not really provide much support for a recovery in Q4 either.
From this point of view, it was not much of a surprise that the central bank finally shifted the risk-balance to the downside. The previous time the ECB changed risk assessment (from downside to balanced) was in June 2017. Nonetheless, no sharp policy implications were communicated and it seems as though the market did not really expect anything else.
Our euro analysts are of the view that the March policy meeting – when an updated staff forecast is presented – will be more interesting. The first line of defence will probably be a new round of liquidity operations. At the December meeting, Draghi said that ‘At some point in time, our committees will start to work on that’. We expect the committees to be tasked formally to examine the liquidity situation next week. Previously, when the ECB made large changes to its monetary policy stance, it has used task committees. How will the Riksbank respond?
The Riksbank board majority has clearly communicated that it has shifted focus from the latest few inflation prints to a more traditional longer term assessment of the outlook for growth and inflation. Could it flip back again?
The Riksbank made some rather significant downward revisions of its growth projections in 2018. For instance, in the September 2018 report, the Riksbank forecast growth in the current year to be 3%. By December, it had lowered that figure to 2.25%. In the meantime, we saw lower projections for 2019. This coincides with some (minor) downward revisions to the projection for underlying inflation (CPIF excluding energy). Note that forecasts further out than two years are not really forecasts in the true sense of the word but rather a convergence of GDP towards potential growth and inflation to 2%.
According to our GDP-indicator, domestic data says that growth remained modest in Q4, particularly consumer spending and housing investments. At the same time, labour market indicators so far remain robust, with a steady increase in employment and vacancies at elevated levels.
The latter is important in the sense that it gives the Riksbank room not to jump to conclusions. Presumably, it will lower its GDP forecasts somewhat at the February policy meeting but, for the time being, we guess that it will stick to the current policy guidance (rate path). In our view, the April meeting should be more interesting. It will have released GDP data for Q4 will have been released (due 28 February), new ECB forecasts and policy guidance will be available and the Riksbank will know whether the Fed is actually on hold. Our guess is that this will result in a combination with, on the one hand, an end to reinvestments in June 2019 (at most we would expect only coupons to be reinvested) and, on the other, yet another delay to the second rate hike. Currently, Riba contracts price in 29bp up to May next year. We see little reason to move pricing higher. We have experienced a significant curve flattening. As we describe later in this document, we have decided to close our positions for a flatter curve. In the US, yields express a recession risk, which we find somewhat far-fetched and some upward correction in yields seems warranted.
However, a few domestic factors also deserve some attention.
First, if our expectations are correct regarding the Riksbank not extending QE beyond June, we believe it would be somewhat negative for longer yields.
Second, with growth slowing we have probably seen the lows in government bond supply. The National Financial Management Authority (NFMA) just released a new budget forecast, showing lower surpluses than in the previous forecast for 2019-20 and lower surpluses than in the Debt Office projections. The Debt Office is due to update its borrowing forecasts next month and, in our view, it will probably also lower its budget projections. So, we believe the risk is skewed towards some upward revision of borrowing.
Finally, it appears to us that the Riksbank (and probably private banks) have convinced households to prepare for higher mortgage rates. One sign of this is that, for the first time, we are now seeing a more significant flow from variable (3M (NYSE:MMM)) rate mortgages to fixed rates. In October-November, the stock of fixed rate loans increased by around SEK50bn, while floating rate loans declined by SEK20bn. If this continues, or accelerates, it could potentially mean less liability swapped covered bond issuance, i.e. somewhat more net risk to the market (i.e. upward pressure on rates).
Relative flattening trend takes a break – curves could steepen in coming months
Since mid-2016, the SEK swap curve has steadily flattened relative to the EUR curve. If we look at the 3Y-10Y box specifically, it has flattened by around 60bp.
If we split up this box into a short and long cross-country spread, it becomes clear that the primary driver for the move has been the 3Y spread versus EUR, while the 10Y spread has moved in smaller increments.
If we look at each leg of the 3Y spread, we see that the SEK 3Y swap has moved up by more than 50bp since the rate bottom in 2016, while the 3Y EUR swap is only a meagre 15bp from the low.
Over the course of 2019, some 20bp is priced in on the Riksbank (with an emphasis on Q3). We find it hard to see much upside risk to this. As we see it, there is a risk that at some point in the spring, the market may increasingly question the rate hike given the domestic slowdown (admittedly becoming more and more mainstream) and the continued lack of wage pressure. At the same time, expectations of the ECB are no doubt muted. This speaks against a further spread widening in the short end.
Therefore, we close our relative flattener 2Y/10Y 1Y forward against the EUR. Despite the steady relative flattening trend, the position has yielded only a 4bp profit. The reason is the negative roll in SEK relative to EUR.
We have also had on an outright flattener in the same 2Y/10Y 1Y forward segment. On the back of the move lower in global rates, the position has delivered positively (profit around 13bp). The uncertainty is where rates go from here.
There is no doubt that the international macroeconomic environment is showing signs of weakness. This is clearly visible in PMI-type indicators. In German rates, we find it hard to see much downside in yield terms. The market has almost completely taken away hike expectations in 2019. On a generic basis, the Bund still trades some 30bp from all-time lows from 2016. In an environment where the ECB is scaling down its purchases after all, we doubt there is much downside unless the euro area is heading for an outright recession (and not just a growth deceleration).
While the picture for Europe is somewhat darker, US data remain relatively upbeat as a whole. However, there are clear signs of weakness in housing as well as in manufacturing, and one could fear that growth will decelerate further once the impact of tax cuts/increased expenditure fades. At the same time, the economy as a whole continues to do well (see chart below). At least in the short run we seem to be heading towards more than decent growth numbers. In our view, the labour market remains impressive.
We cannot rule out that in the longer run we will get caught in a more negative scenario but current pricing is aggressive. In US rates, we are close to a recession-like scenario. We are not there yet, so we see a risk of a move higher in rates. Therefore, we close our outright flattener as well.
How would such a scenario affect Sweden? We reason that there is a likely to be resistance against moving up SEK short rates (to say, around 3Y) unless pricing on the ECB moves as well. What happens internationally would affect longer rates more.
During the recent move lower in rates, the 5Y point has outperformed significantly. Since mid-October, the 2Y-10Y spread has flattened by almost 35bp. However, the 5Y-10Y curve has flattened by only 7bp, while the 2Y-5Y spread has flattened by 27bp. We see the 5Y point as exposed to a sell-off.
The long end could also be affected by higher borrowing requirements (risks are, in our view, skewed on the upside) and/or a possible end to QE beyond June 2019 (our main scenario).
Thus, we think it is time to position for higher rates. For SEK rates, this should mean steeper curves. We prefer to play the 3Y-10Y segment. Therefore, we recommend paying 10Y swaps versus receiving the 3Y swap (86bp). We set the P/L levels at 105/70bp.
Current risk sentiment affects FX markets
Following the Riksbank’s December rate hike, EUR/SEK has mostly been trading in the 10.20-30 interval with only temporary breaches. Although a notable event in its own right, the first rate hike in seven years has yet to prove to be a game changer for the SEK. Cross checking with our short-term financial models using interest-rate differentials and a proxy for risk sentiment, suggests that EUR/SEK trades marginally on the high side of fair value which is close to 10.20.
As we argue in FX Forecast Update – EUR/USD rocket – now on the launch pad, 21 January, the dovish leaning of the hike and poor risk sentiment have capped the downside in EUR/SEK. We expect the apparent global slowdown and a domestic deceleration of housing investments to weigh on the Swedish economy in 2019, which in turn is a potential headwind for the pro-cyclical SEK. Thus, we see only limited downside potential in EUR/SEK from today’s levels. This is reflected in our forecasts, where we see the cross at 10.10, 10.00 and 10.00 in three, six and 12 months respectively.
As stated above, poor risk sentiment is in general negative for the SEK. Looking at historical correlations between the global equity index MSCI and couple of currency pairs, we see that the usual suspect JPY seems to offer the best protection during stock market corrections and this is especially true versus the SEK. The other two major currencies included (EUR and USD) have also fared well against the SEK during major equity selloffs.
Although correlation must not be taken for causality, it might still serve well to remember this as we move forward into 2019. On top of continued uncertainty regarding the USChina trade deal still to be negotiated, we also have a prolonged Brexit process to consider, which adds to the financial markets’ uncertainty. If the sour risk sentiment is here to stay, we are hard-pressed to find reasons to be overly SEK bullish moving forward, regardless of the December hike. That said, our base case is that a hard Brexit will be avoided, while China and the US will eventually strike a deal – if so, this would be risk friendly and an argument for some stabilisation of the SEK over the course of the year.