Strategy - Sweden: Reduce Delta Sensitive Positions

The outcome of the Italian election where the Bersani coalition seems to have secured a majority in the lower house but fails to reach majority in the senate is particularly unfavourable and opens the way for a renewed period of political uncertainty and financial stress in Europe.

Accordingly, we need to undertake some adjustments to our list of recommendations in order to protect our positions for financial turbulence in the aftermath of the Italian election, generally decreasing the overall risk exposure.

In short, our list of key trades can be described in terms of the following.

Steeper curve in the 2/5Y segment (long SGB 1049 versus SGB1052).

Long mortgages versus government in the 4-5Y segment (for instance, long SWH185 versus SGB1051) and extensions along the mortgage curve relative to swaps.

Short delta at the portfolio level.

Underperformance of longer dated index-linked bonds, i.e. tighter 10Y break-even spreads.

Tighter ASW spread in the 10Y segment both outright and relative to short covered bonds.

Pay the Swedish very long end versus EUR in the 15Y segment.

Given the situation that has emerged in Italy, the most important thing right now – until we get a better feeling for how the political landscape will evolve – is to reduce the overall short delta exposure. Given our mix of trades, we have in practice been shorter delta than the net delta number would indicate, as we have had a predominance of ‘risk on’ trades.

As the political landscape has now become close to unpredictable in Europe, we find ourselves forced to reduce the overall risk exposure. We are less confident that rates will continue to rise in the near term.

However, domestically we are reluctant to abandon the exposure to covered bonds. We are aware that mortgages can be expected to underperform, at least initially, as government bonds rally. The supply picture is, however, likely to support further spread compression in the near term. We expect more EUR issuance in the coming month and large index extensions in April to June should keep longer covered bonds in demand. Thus, we choose to keep the exposure towards covered bonds.

Also, the takeaway from the Riksbank minutes published today was that the Riksbank majority sees signs of stabilisation in the Swedish economy and the likelihood of another rate cut has clearly diminished. Historically, the 5Y segment has tended to perform weakly in the months following the last rate cut in a cycle.

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