Trade Recommendation: Real Rate Steepener‏

Open position at +77.5bp. Potential target at +100bp, stop at +60bp. Carry +15bp to December 1 given our inflation forecast.

Steeper curves? Yes, but risk/reward better in linkers

There is room for more steepening of the Swedish bond curve but we find it more attractive to do such a steepening in linkers instead of in nominal bonds. Let us elaborate on this by first assessing the long end of the Swedish yield curve. After a few years of low (negative) risk premiums in yield curves, amid aggressive unconventional monetary policy (QE), the long dated real rates dropped to unprecedented low levels. As discussions about Fed tapering emerged, real rates started to move gradually higher in the spring. This has been supported by signs of some improving outlook for the western economies. The contagion also pushed Swedish long dated real rates to all-time lows. The 1Y real rate 10Y forward reached its bottom last summer at 0.15% and since then the 1Y forward rate has climbed to currently 1.15%. However, by historical standards, this is still low and, given the level of the 2Y real rate, the longer real rates have room to climb more (see Chart 1). Moreover, the long-term inflation expectations are not exceptionally low, close to 2% (see Chart 2) and thus a further rise on long dated interest rates should primarily be a result of higher real rates, consisting of risk premiums and a better long-term growth outlook.

At the short end of the curve, inflation expectations are still very depressed despite a recent uptick in short BEI rates, see the Index-Linked Report from 28 August for more details. So, at the short end, we see little room for real rates to climb even if nominal bond yields inch higher still. The real repo rate will continue to be very low over the next year or so, which will be another obstacle for short real rates to move considerably higher.

The Debt Office will start to buy back the short bond SGBi3105 in December. The buybacks are planned to be done in three switch auctions in December and in the first half of next year. The total amount the Debt Office is planning to buy back in the auctions is SEK20bn. This will most likely be supportive for short linkers.

We recommend, as a long-term strategic strategy, buying SGBi3105 versus SGBi3108 in a real rate steepener.

To Read the Entire Report Please Click on the pdf File Below.