European FI Strategy Buying this, but not that. Yet Nordea Research, 25 September 2014

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1 first FI Strategy European FI Strategy Buying this, but not that. Yet Nordea Research, 25 September 2014 Global markets The ECB appears to be prepared to do whatever it takes, and the poor TLTRO is likely to generate even higher market expectations of further easing measures. In other words, the markets are set to price in an even higher probability of the ECB buying government bonds. Such expectations should keep Euro-area bonds supported, pushing core yields even lower. EUR Strategy Draghi recently seems to be distancing himself from the 5y5y inflation swap measure. We argue that that measure in any case is a poor measure, and highlight that the more logical part of the curve (2y2y) in fact has been successfully raised by the ECB through a weaker euro. Short term we like receiving this elevated level. We look into the prospective minimum levels of both Eonia and Euribor 3M fixings, and find that Eonia only temporarily should go below -10bps and that Euribor is likely to minimize at +3-4bps. Intra-Euro-area spreads look set to narrow further despite resistance. We expect Italy to do well vs Spain and France to perform vs Belgium. Sweden We see the rate forecasts of the Riksbank as essentially an upside risk scenario. On the SEK curve, 5s10s has lagged in terms of flattening and receiving the 10Y point or alternatively 5Y5Y looks a good relative bet. Norway The chance of a fall cut is real. We like front end steepeners near the front and spread narrowers vs. European due to a lag of Norwegian rates. Denmark Recently DGBs have bled in the 5Y segment. With the ECBs bond programs kicking off soon, Danish bonds are likely to perform. The risk continues to be for a cut in the CD rate, but at this stage such action is not imminent. Chart of the month: Shorter inflation swaps up with weaker euro Editors Lars Peter Lilleøre Chief Analyst IR products lars.peter.lilleore@nordea.com Jan von Gerich Chief Analyst Fixed Income jan.vongerich@nordea.com Contents Global Markets Overview....2 EUR Strategy...3 Liquidity jitters Inflation...5 Scandi Corner Swedish rates...6 Scandi Corner Norwegian rates...7 Scandi Corner Danish rates...8

2 Jan von Gerich Chief Analyst Fixed Income jan.vongerich@nordea.com ECB to find it increasingly hard to meet implied balance sheet targets with the measures announced so far. Markets to price in more easing from the ECB. Unchanged forward guidance from the Fed relieved the pressure on US Treasuries. Global Markets Overview Much less than it takes Draghi clearly set the bar high, when he said the ECB aims to significantly steer, the size of our balance sheet towards the dimensions it used to have at the beginning of Earlier this week, Draghi said we are starting a transition from a monetary policy framework predominantly founded on passive provision of central bank credit to a more active and controlled management of our balance sheet. In other words, the ECB appears to be shifting the way it conducts monetary policy: if the set targets cannot be met with the measures announced so far, more will be needed. The first targeted longer-term refinancing operation (TLTRO) saw only EUR 82.6bn of demand. Even though the ECB has tried to play down the significance of the first operation and the second operation will most likely be considerably larger, the risks are now clearly tilted towards the downside as far as total TLTRO demand is concerned. To reach the balance sheet size Draghi implied would mean a rise of around EUR bn. Taking into account maturing LTROs, the TLTROs and bond purchases should amount to at least EUR 1 trillion, which looks quite unlikely, especially after the first TLTRO (see more here and here) As Draghi actually appears to be prepared to do whatever it takes, as illustrated by his determination to push through another easing package already at the September meeting, the disappointing TLTRO is likely to generate more expectations of further easing measures ahead. The recent weakening momentum in leading indicators, like the PMIs, will only add to such expectations. In other words, the markets are set to price in an even higher probability of the ECB buying government bond purchases ahead. Such expectations should keep Euro-area bonds supported, pushing core yields even lower. In the US, the Fed s median interest rate forecasts were lifted again. Markets, however, appeared to pay more attention to the unchanged forward guidance, and the re-pricing of the Fed outlook seems to have stopped for now, even though the fed funds futures currently price in significantly less easing compared to the FOMC median forecasts. A sell-off in US rates thus does not appear to favour higher EUR yields either in the near future. Chart1. Recent data boost ECB easing expectations Chart 2. First TLTRO allotment nothing to cheer about 2

3 Jan von Gerich Chief Analyst Fixed Income jan.vongerich@nordea.com Italian bonds to perform vs Spanish ones, French bonds vs Belgian ones in the near term. Lars Peter Lilleøre Chief Analyst IR Products lars.peter.lilleore@nordea.com With a large part of the front ECB-anchored, many curve trades are pure directional bets. Bear steepeners should include the 20Y point EUR Strategy Spreads & Curves Narrower spreads despite resistance Italy to perform vs Spain As spreads reach even narrower levels, it naturally makes sense to question the validity of the rally. With e.g. Spanish and Italian 10-year spreads vs Germany approaching 100bp, there are increasing doubts about how long spreads can continue to rally. The short answer is that the rally will most likely continue for now, as more easing from the ECB is priced in, but it will not be a one-way street. As a rule of thumb, the wider the spreads, the more narrowing potential there is. Even though Spanish bonds should benefit from any ECB government bond purchases more than Italian ones (since the Spanish bond market is smaller relative to the size of the Spanish economy compared to the Italian one), Italian bonds are likely to outperform Spanish ones in the coming weeks. The reason for the relative Spanish underperformance should be the uncertainty over the independence quest of Catalonia, where a referendum on the matter could be called for November. Belgian bonds have rallied a lot, so much actually that some Belgian bonds trade below the French curve in the 5-year sector, while the pick-up over France is only a few basis points in the 10-year sector. While there is no denying the French outlook appears rather awful, in the near term French bonds are likely to find demand vs Belgium at these levels. Swaps it s not all about the short end Lost a little bit in the scuffles in the short end are moves further out on the curves, the EUR swap curve in particular. That 5s30s, 2s10s and the like has steepened since the ECB in September and that those trades are close to directional bets, is quite clear which to a large extent is reflected in the cost of doing conditional bear steepeners (expensive). More interesting curve dynamics can in our opinion be found around the 20Y point and beyond. There, the late August lows and we re still close renewed the old tendency of the long end getting bid. So 30Y rates down, but the 20Y segment more so which is a consequence of the regulatory changes for the life and pension sector since mid Steepeners designed for bear scenarios should consider paying the 20Y point, which perhaps is even clearer in the flat spread between forwards 15Y5Y and 10Y5Y. Chart3. Belgian bonds performed a lot vs France Chart 4: Strategic steepeners should include 20Y 3

4 European FI Strategy EUR rates liquidity jitters Gone are the days of 100bn and below Lars Peter Lilleøre Chief Analyst IR Products Alexander Wojt Analyst Fixed Income Strategy Research Sweden alexander.wojt@nordea.com Liquidity has once again become a hot topic after last week s first TLTRO operation. The somewhat disappointing 82.6bn uptake was met with a 19bn repayment in the 3y LTROs and a 15bn reduction in the weekly MRO, thus increasing net excess liquidity with roughly 50bn. This will be enough to have an impact on the EUR short end, but is markedly lower than expected. Looking ahead, the important factor in terms of liquidity for the coming month will probably be the ECB s clarification of the ABS and covered bond programs. A possible announcement of size and pace should provide more clues in terms of the liquidity trajectory in the year to come. Most likely, it will take a significant amount of time before the 100bn level is reached again. The December TLTRO uptake plus the six subsequent re-fills together with the bond programs could keep liquidity ample over years to come. Thus, the ECB s soft balance sheet target will have direct effect on the liquidity situation in the Euro area, and thereby also the EUR short end. How low can we go on fixings? This is an inherently difficult question to answer but should include the wellknown inverse relationships between excess liquidity and the spread from market fixings to the depo rate. In addition, market implied pricing on both Eonia and Euribor should be internalised, as should the realization that history doesn t necessarily extrapolate to deeply below zero. Prior to the first TLTRO-takeup we treated these issues at length (see here), and while our estimate for the first uptake was too high, we did highlight the risks to the downside in general on the TLTRO-trajectory as well as the inherent optimism in the ECB balance sheet projections. The ECB can tune up the expectations for the ABSPP and the CBPP3 programs on October 2nd. Excess liquidity back in the range of bn would indicate an Eonia fixing about 6bps above the depo, at par with what we saw at minimums in With risks for lower excess liquidity than this, we see Eonia only sporadically below -10bps, and longer averages should not go below -10bps. The pricing of FRA/OIS in the market is future levels in the 13-15bp range, and as such we still see a minimum Euribor 3M fixing at 3 to 5bps, less than current market implieds, but not by a huge margin. Chart6. Current Market Implieds, Euribors & 3M Eonia swaps Chart5. EONIA fixing and excess liquidity 4

5 Lars Peter Lilleøre Chief Analyst IR Products At any rate, the 5y5y inflation swap rate is a bad measure. Draghi seems to recognize this, and recently avoided referring to the measure. Downside risks dominate for the coming flash estimate. ECB has had some success on 2y2y inflation swap rates. The risk picture now favors receiving the new elevated level. Barking up the wrong tree on inflation While 5y5y is nearing an abyss, shorter expectations have risen 5Y5Y inflation has long been a standard entity for participants on inflation and real rate markets. While the US version has been referred to previously and plentiful by the Fed, EUR HICPxT 5y5y inflation, seen as an expectation has only recently gained strong traction as an important market entity. The reason for this lies with Draghi s Jackson Hole speech on August 22 nd where he explicitly referred to the 5y5y swap rate as the metric we usually use for defining medium term inflation. Theoretically speaking the first problem with this is that the 5y5y swap rate is not a physical expectation, it is at best equal to an expectation plus a risk premium that can change dynamically (even in terms of its sign). Further, the inflation market can be thin, and moves in particular segments can arise due to carry flows etc. As such, it is not an entity on which you want to explicit conduct monetary policy. The recent speech from Draghi in Brussels (September 22 nd ) indicated as much; there was no 5y5y reference this time. That is sensible in our opinion because if it was a firm target what do you do in the face of the recent most movement, cf. chart below. On the short term, risks are quite high as the September print is expected to come in fairly low (albeit the expectation has increased since August, cf. chart). We see clear downside risks to the implied 0.25% y/y for September which if materialized can pull down or reverse the recent upwards movements in the front of the curve, e.g. the 2y2y inflation swap. This inflation swap is a really a more prudent and direct measure when looking at the shorter term efficiacy of monetary policy. One could argue that the ECB has actually succeeded there, cf. the 20bp+ rebound in the measure over the past month. This to a large extent has been driven by the weaker Euro which again is a function of the money market rate gap between EUR and USD rates, cf. the gap in the lower right chart. In the short term govie-qe is unlikely to come, and the reality we re currently facing is excess liquidity coming in lower than previously anticipated, with less pressure down on short rates, and stabilizing the euro. This, combined with the susceptibility of short inflation swaps to downside surprises on prints, to us means that receiving 2y2y is the right trade to do right now at around 1.27% y/y which rolls 26bps over the first year. Chart7. Both 5y5y and September fixing spell trouble Chart8. 2y2y has been impacted, through the EURUSD 5

6 Scandi Corner Mats Hydén Chief Analyst Fredrik Floric Chief Analyst The Riksbank s rate forecast continues to indicate an upside risk scenario A future downward rate revision is expected to target the ECB level SEK swap rates are back at all-time highs relative EUR Swedish Rates rate path revision bias keep SEK rates supported Since the previous rate meeting on 4th of Sep, both ECB and Norges Bank have come out with new information. While the former surprisingly decided to cut the refi rate down to 0.05%, and launch a credit easing program, the latter found reasons to be somewhat more optimistic on the domestic economy (following strong data in the summer), which resulted in a deletion of the near-term easing bias. This was less dovish, but at the same time, the rate path was revised lower further out and the first rate hike pushed out to Q1-17. As chart 9 on this page clearly illustrates, the Riksbank continues to have a rate forecast that very much looks like an upside risk scenario rather than a base-line one. This systematically built-in decoupling assumption is also something that clearly begins to bother several Riksbank board members, which we learned from the Minutes. So, what ECB and Norges Bank did just highlight the urgency to revise lower its path of rates, if credibility is prioritized. The key question is then how the bank would tackle it? A large revision over 1 or 2 meetings together with another rate cut, or small revisions in gradual steps without changing rates? Another large downward revision is something which markets already discount to a large extent (125bps lower end-point). However, in relation to this, rate action at the October or December meetings is something the market price in to a lesser extent. If they would cut again, it would mean cutting the repo rate to an unprecedented level. As the SEK 5-10y curve has lagged the flattening in other markets, SEK rates are back at all-time highs vs EUR in for example 5y5y. Depending on your view on the prospects of ECB launching a major QE package or on your view on global curve trends, the SEK 10y segment sticks out as a value-added receiving point. We consider SEK 5-10y as a preferable choice for a curve flattener compared to other markets. Also receiving SEK 5y5y vs EUR is an interesting alternative. Any credible action from the ECB might push EUR rates up more than SEK, where no QE expectations are present. Chart9. Repo rate path a main or risk scenario? Chart10. SEK 5-10y lagging EUR and USD 6

7 Gaute Langeland Chief Analyst Next year s growth perspective presents a small chance for a rate cut Norwegian Rates attractive entry levels in front end steepeners The June Monetary Policy Report surprisingly opened the door for a rate cut this autumn. Last week Norges Bank took the markets by surprise again and removed the easing bias on the back of strong growth and inflation figures together with a weaker krone. This means that Norges Bank is back on hold and expects to remain so for the next couple of years. The short end is anchored for now, but falling petroleum investments next year sets the major growth engine for the Norwegian economy into reverse. This gives rise for concern, and justifies that the (still) somewhat inverted FRA-strip signals a small chance for a cut next year. Risks to rates are skewed to the downside although this is a medium term story. In the near term, cuts in Banks mortgage rates are likely to materialise and get focus as Norges Bank typically let this affect the rate path upwards with a factor of about 0.5. So a 25bp cut in average mortgage rates would be a positive surprise, but not enough to trigger a hike on its own. With little traction in domestic monetary policy the market should take its cue from global markets. Correlations to global long end rates should remain high and the curve should continue to bull flatten / bear steepen. Potential trades that have attractive entry levels at the moment are steepeners in the front end (largely a directional bet, but better risk reward paying fixed due to the flat entry levels) and spread narrowers vs Europe. Norwegian rates typically lag in a falling rates environment, so we have ended up with high spreads to EUR after the recent moves. But Norges Bank is also an important driver for the spread when it is expected to adjust rates. Selling the spreads is a bet of one of two things happening: 1) higher global rates or 2) rate cuts being priced again. The shape of the spread curve let us run this position with positive carry, not bad for a position with a bias for higher global rates. The 3y2yfwd spread is 178bp, whilst it is 165bp spot. The 5yr sector on the NOK curve has underperformed recently with 2s5s10s now trading at -21bp. The on hold stance from Norges Bank should ensure that this remains low or even fall back towards the recent lows of about -30bp. In total we like selling the 3yr2yr fwd spread to EUR as a medium term trade. Chart11. 2s10s long end is the driver of the curve Chart12. Spreads to EUR are high in the 2-5yr segment Source: Nordea Markets and Bloomberg 7

8 European FI Strategy Danish Rates: Stronger DKK and sub-zero deposit rates Niels Blixenkrone Chief Analyst The interest rate cut from the ECB and the Danish central bank on Sep 4th took the market by surprise, and both DKK and German bonds rallied 3-4 bps in sync in the front. Since then DGBs have lost 4-5bps in the 5y segment for no obvious reason. The announced expansion of the ECB s balance sheet will most likely support Covered Bonds and SSAs with possible spill-over to govies. This could easily pave the way for an influx of EUR and Danish bond performance - and maybe even an additional Danish cut down the road. However, no such cut is factored in as chart 14 suggests. Danish assets are directional Danish assets are directional: The current issuance in long dated callables of some DKK 0,5-1 bn is manageable, but a further rally could easily boost issuance and demand for delta which talks in favour for buying govies. If, on the other hand, rates go up Denmark is likely to underperform peer countries due to an oversupply of delta. Over-all the price of DGBs balances between potential QE related performance and adverse effects from the highly negatively convex covered bond market. On the margin we see the recent small dis-performance as a buying opportunity in the 5-10y sector. Chart13. EUR/DKK and central bank intervention Chart14. No Danish relative hikes factored in 8

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