Strategy Sweden: Buy SWH186 Vs SGB1041‏

We recommend buying SWH186 versus SGB1041. Very muted supply of five-year covered bonds and too much rate cut priced near term support the trade. In addition, this flattener offers a very good carry, nearly 5bp /month plus an additional 1.5bp/m in roll down.

We have for quite some time now had a positive view on Swedish mortgage bonds, which we have expressed in various trade recommendations. A fundamental reason for this is that we foresee a very muted supply of mortgage bonds in the coming year, both as a result of a marked slowdown in mortgage lending and hence the need for funding and due to the fact that mortgage institutes in general already are pre-funded well into next year and in some cases a good part into 2014.

Swedish macro data of late have signalled a rather steep decline, especially in the export industry and lay-off notices have risen sharply. At the same time, other labour market indicators are still mixed. Unemployment has been rising slowly over the past year but the same is true for employment.

A traditional analysis of recent information would undoubtedly suggest a rather high probability of a December repo rate cut but at the current juncture one must also weigh in the fact that Riksbank Governor Ingves – backed by several other board members – in recent weeks has expressed considerable concern regarding Swedish households’ gross debt (currently some 170% of disposable income) as the most profound potential threat to economic stability.

The market is currently pricing in a 20bp rate cut (80% probability) in December and another 15bp (60% probability) in February. Even if one can make a reasonable case for a December cut, we feel that such a decision is far from evident and the total of 35bp up to February appears stretched. In any case, given the implied high probability of policy easing

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