FI Strategy. Chart of the month: Long rate/vol correlation has turned quite negative. Editor

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1 first FI Strategy European FI Strategy Volatility back for good Nordea Research, 30 October 2014 Global markets Volatility is back, with some huge swings in the corest of rates over the last weeks. We do not forecast panic, but see realized volatility likely to pick up over the docile levels of much of Hawkish Fed yesterday helps the ECB primarily through drops in the EURUSD, and the ECB needs all the help they can get. Though the stress tests were positive, risks persist as does the pressure on Draghi et. al. to deliver more. EUR Strategy Since early September, the Eonia swap market has systematically undershot fixings and as a result, the very front end of the MM curve has moved up, but shorter forwards are still low. We like flatteners on the Eonia curve. The ECB-anchor on the front of the curve looks overstated in implied vols, and 3M5Y receiver swaptions are very cheap. On the long end we favor 10s30s flatteners, but outright it is too costly, so we go for swaption variants utilizing recent price patterns there. Sweden The end of the line for the Riksbank after cutting the repo rate to zero. The 10Y point on the SEK curve is likely to be the focal point for any re-pricings. We like the still high 5y5y swap spread over EUR. Norway Drops in oil prices mean drop in shorter NOK rates, and the pressure is there for a cut from Norges Bank, but we see the market pricing too far. The FRA strip is about 40bp below their rate path (from mid-2015).. Denmark Danish covered bonds are trading at levels comparable to Spanish Cédulas and we find this counterintuitive. Further, spillover from the ECB s CBPP3 we see spreads and rates with a bias for further tightening. Chart of the month: Long rate/vol correlation has turned quite negative Editor Lars Peter Lilleøre Chief Analyst IR products lars.peter.lilleore@nordea.com Contents Global Markets Overview, govie spreads and curve....2 Long end of the curve what to consider...4 EUR rates money market tightness Scandi Corner Swedish rates...7 Scandi Corner Norwegian rates...8 Scandi Corner Danish rates...9

2 Jan von Gerich Chief Analyst Fixed Income jan.vongerich@nordea.com Huge swings in markets, triggered by growth fears. No reason to linger on the ECB stress test results. Bond yields with more downside potential. Global Markets Hitting brick wall, again? Volatility made a comeback earlier this month, with a vengeance. Within a single day (and a large part of the moves taking place within minutes) the US 10-year plunged by more than 35bp, followed by a jump of 30bp. Big moves were seen in other markets as well, including huge swings in intra- Euro-area spreads and finally some sizable falls (albeit rather short-lived) in the equity markets. The German 10-year yield plunged to a new low of 0.72%. The rapidness of the subsequent rebound suggests yields are finally finding support at such low levels. The huge moves came after recent economic data had created fears of a slowdown in emerging markets and another recession in the Euro area. The final straw seemed to be a worry of the weakness spreading into the US, as September retail sales disappointed. The large moves illustrate the changed market environment, and similar swings could easily be seen in the future. There is no doubt that growth in China will continue to slow due to structural reasons, while the Euro-area outlook remains grim. Still, some of the recent figures, like German August industrial data and the mentioned US retail sales report overplay the weakness. Negative data surprises have since evened out a bit, while both core bond yields and equities have rebounded (in the US, equities are back to close where they started the month). The much-vaunted ECB stress tests came and went, with the weak German Ifo helping to spoil the initial market relief. The tests were more credible than the similar exercises done before, and remove one obstacle from bank lending growth. Yet, other obstacles remain and the macro environment will continue to be challenging. Debates about whether the tests were sufficiently strenuous goes beyond the point, and is largely irrelevant at this point. Going forward, the continued lack of inflation pressures, weak Euro-area economic performance, risks of more market turbulence, high geopolitical risks and increased focus on what else the ECB could well leave bond yields with more downside potential in the near term. Signs of inflation pressures picking up remain key, but so far there are not many indications of price pressures building. Despite this, yesterday s FOMC minutes were quite hawkish also regarding inflation expectations. Chart1. Economic data lost some momentum Chart 2. Inflation expectations with clear falls lately 2

3 Jan von Gerich Chief Analyst Fixed Income jan.vongerich@nordea.com Italian bonds to feel pressure vs Spain. We remain negative on Finnish bonds. Lars Peter Lilleøre Chief Analyst IR Products lars.peter.lilleore@nordea.com 5s10s has flattened, but there s more life in the 5Y point than implied vols dictate. Cheap protection in gamma options on 5Y tails. Spread narrowing not over Finland no longer AAA Spreads have snapped a bit wider from the lows reached last month, as the validity of the huge rally seen has increasingly been questioned. It seems likely spreads will move without a clear course in the very near future, but it would be premature to declare the trend of narrowing spreads to be over. After all, the search for pick-up as a driver has not lost its strength yet, as the ECB continues to contemplate more ways to provide easing. A central bank in an easing mode should continue to cap the upside potential for spreads in general. Italian banks did not perform that well in the ECB s comprehensive assessment. Even though no bigger sell-off looks likely, Italian bonds are set to feel more pressure vs Spain in the near term. Finland lost its AAA rating from Standard & Poor s earlier this month, while Moody s and Fitch still put Finland in the triple-a category. The Finnish bond market largely ignored the rating move. Because of the continued weak momentum in the economy and the slim chances of real reforms in the near term, we retain a negative stance on Finnish bonds. Curve docile for over a week now, but large moves are not far away At least in the historical distance it has been a mere two weeks since we saw outright panicky moves with e.g. the 10Y swap rate below 1% and the 30Y rate almost in 1.65% intraday mid this month (cf. also the points made on the previous page). In general, as the Fed faces a tightening circle and speculation runs amok on the additional ECB measures, we expect realized volatility to pick up over the levels encountered in recent years and indeed, while we see rates rising in our base case (very modestly on EUR rates), further detours downwards cannot be discounted. We look into the 10Y+ segment on the next pages, but note that 5s10s on the curve also has gone quite flat (below 60bps two weeks ago, and around 62.5bps now). Also, the supposedly ECB-anchored 5Y swap rate has moved almost 10bps, not a huge move in any historical sense, but large given the near all-time lows we re seeing on gamma vols on 5Y tails (e.g. 3M5Y in just 31 bpvols). The break-even for a 3M5Y receiver swaption currently is just 0.47%, a quite cheap protection for a repeat of the moves of last week. Chart3. Further spread narrowing met resistance Chart4: Even on 5Y tails, realized vol has picked up a bit 3

4 Long end of the curve what to consider Lars Peter Lilleøre Chief Analyst IR Products Correlation between swap rates and vols are back to being strongly negative for 30y tails. 10s30s risk/reward and how to play it With the ECB owning a large part of the front of the curve (though this should not be taken too literally cf. our points on the 5Y point earlier), much of the interest has shifted to the pricing to the long end of the EUR swap curve, both in terms of levels and in terms of slope. Here we dig into the 10s30s, and investigate (1) which way to position given risk/reward, (2) the cost and risks of doing so, and (3) the best variant of the position to take. Forced hedging means negative correlation (again) The ongoing process of regulation for Life and Pension funds across Europe is a complex process of longer duration. It is hard to impossible to ascertain how much forced hedging there remains, but what is clear is that changes to discounting curves and a large reduction in fixed rate guarantees for policy holders, overall reduces the need for receiving the very long end of the curve in times of distress. That there remains some not that latent receiver hedging in the long end of the curve has been quite clear over the past months, and what we can call throwback pricing has come into focus once again, though to a lot lower extent that in e.g. the middle of As is evident in the chart below, the running correlation (6M running window) between the 6y30y bpvol and its associated forward swap rate has recently gone significantly negative after having been positive for almost a year and a half. It is not (yet least) attaining the near perfect negative correlation we saw in 2011, but it is in fact lower than mid-2012 though the day-to-day swings are less now. Chart 5: Correlation dynamics on 30Y tails: Back to strongly negative Though our official forecast on EUR swap 10s30s is flat, longer term the risk lies with a flattening move from 10Y rates moving up more than 30Y rates (and indeed moving somewhat towards the US curve). On a short 4

5 European FI Strategy horizon, renewed flare-ups of what we saw two weeks ago cannot be discounted, and the potential for flatter 10s30s through the correlationargument from above is quite likely. Our preferred view is for 10s30s to flatten on the EUR swap curve The logical position would thus seem to be a 10s30s flattener. The problem here is that that costs in terms of roll & carry. For instance, 10s30s, 6m forward sees a roll against of 7bps (each with a dv01 just short of 24). Going non-linear makes sense given recent vol-richness on 30Y tails Risk vs. reward vs. carry costs means that non-linear alternatives should be investigated. This is boosted by recent volpricing. Going non-linear helps somewhat on the latter part, as vols on 30Y tails have been bid up relatively to 10Y tails recently, cf. charts 2 & 3. This means that when selling. 1y30y payer swaptions delta-neutral against 1y10y payer swaptions, you get an upfront and a reduced delta on the swaptions so that curve roll against you is diminished. This cannot make the trade roll positively, but making the swaptions out of the money (atmf+25bps) reduces the 6m roll against from 60bps to 22bps (in absolute terms) and in 1 year with an unchanged curve the trade will leave you with the positive upfront in your pocket against a 300bps+ (on the notional) loss on the swap. This type of exposure is primarily for rate-up scenarios as the highest profit will come from 10Y rates surging. It is important to note however that given a repeat of the aforementioned throwback pricing, the options will go out of the money, but your short asset more quickly so, leaving a window to take profit on this bull-flattening if it comes in force (especially if it comes soon so that time value remains in the swaptions). All in all, payer swaption structures give the best mix of exposure when factoring in the risk and the cost as well. We have chosen 1 year expiries here due to a trade-off between recent relative richening and timing considerations, but the arguments work fine for 6M as well, cf. again the charts below for a view of the relative cheapening of the 10Y tail vols. To us, payer swaption structures are the safest way to position in the longer end whilst also ensuring a sizeable payoff if we re right. Of course, full conviction means that the view should be taken in swaps (receive 30Y and pay 10Y); for less brave souls, we recommend a payer swaption variation. Finally, the alternate position, the 10s30s steepener typically in forwards, is rightfully a classic in terms of almost always rolling strongly. If this position is undertaken, we d recommend doing it in longer dated expiries/forwards, potentially as long as 5Y which is the segment on 30Y swap tails that looks the cheapest currently. Chart 6. 30Y vol now relative to before June easing Chart 7. 10Y vol now relative to before June easing 5

6 Lars Peter Lilleøre Chief Analyst IR Products Alexander Wojt Analyst Fixed Income Strategy Research Sweden alexander.wojt@nordea.com Of the last 34trading days, 1 week swaps have undershot fixings 32times. In terms of risk/reward, Eonia curve flatteners are the best bet. EUR rates money market tightness Gone are the days of 100bn and below Since early September there has been a tightening trend seen in the EUR money markets. Even if the first tranche of the TLTRO boosted excess liquidity somewhat it wasn t enough to keep it above the 100bn level where the Eonia fixing historically has had a tendency to drift towards the refi rate. This has put upwards pressure on Eonias in the short-end (see Market struggles with Eonias ) and led to a tightening in Euribor/Eonia as well as short ASWs (see Schatz spreads & the AQR/stress tests ). Taking the ECB at face value, the communicated soft balance sheet target should increase also excess liquidity over the coming year. However, short term, there are caveats when outlining the liquidity trajectory (Fig 1, details in A liquidity roadmap revisited ). The second TLTRO tranche will be launched in the second half of December and the normal year-end tightness in liquidity coupled with the 3y LTROs maturing in late January and February next year make the timing important for trading the EUR short-end. In addition, pace and size of the ECB s new purchase programs are not known in detail and are also clouding the liquidity landscape. Eonia swaps have been biased for quite some time Several indications on the short horizon point towards excess liquidity finally picking up among them net-inflows from both the 7day MRO and the 91day operation recently, and indeed also a faster than anticipated pace on the CBPP3. The fact remains however that the market in terms of the shortest viable swap (1 week) consistently has undershot Eonia fixings ever since the ECB slashed the depo to -20bps in early September, cf. chart 9. After this prolonged period of misfiring, the front of the Eonia curve looks fair to us now, but short dated forwards are still quite low with e.g. 6M6M at -5bps. We loved paying that outright when it was near -10bps, but continue to like it now but in flattener trades, e.g. 6M2Y vs. 6M6M should be well exposed for a slow build-up of the ECB balance either through the existing measures, but in particular if more eventually arrives. In the mean time they roll positively, and have limited downside at the 2.5Y year point on the curve is very unlikely to get re-priced anytime soon (in a manner reminiscent of the big sell-off in 2013). Chart 8. Liquidity projection for the years ahead Chart 9. Market biased on fixings for a long time 6

7 European FI Strategy Mats Hydén Chief Analyst Fredrik Floric Chief Analyst Scandi Corner Swedish Rates As the policy rate in Sweden seems to have reached the end of the line (set at zero with no indications of the rate going negative in any of the Riksbank s alternative scenarios) and unconventional policy tools are not on the table currently, Swedish rates should trade more on macro and less on central bank stance. Volatility in the 0-5y part of the yield curve should be much reduced going forward. At the same time the 10y+ part of the yield curve is very illiquid compared to the Eurozone. This means that in the current environment, the 10y point will most likely be a focus point when it comes to repricing. So SEK 10y rates should have a tendency to trade with a higher beta to EUR 10y going forward. Apparently there seems to be multiple arguments for both a steeper and a flatter curve With a lower policy rate than any other market, one would expect the Swedish yield curve to be one of the steepest. At the same time, the global flattening trend seems to be more or less intact and SEK 5y5y in spread to EUR is still at high levels given where the 2y2y spread is currently. Apparently there seems to be multiple arguments for both a steeper and a flatter curve. In general we consider cross-market comparisons less and less valuable, and views on the slope of the yield curve should be anchored in each domestic market and on a view on outright long-end yields in general. In this context, the high-beta characteristics of the SEK 10y point makes it an attractive choice of implementing views both on the upside and downside in rates. When it comes to SEK covered bonds, we find it hard to imagine a more favorable environment than the current, so if the 5y ASW spread is to close in on zero and eventually go into negative territory, it is surely now. Chart 10. Repo rate at 0 implies all-time steep 5-10s? Chart 11. SEK 5y5y high relative 2y2y, but for a reason? 7

8 Gaute Langeland Chief Analyst Ole Håkon Eek-Nielsen Chief Analyst Only the disappointing global growth outlook and falling global markets, in particular the oil price has surprised to the downside The Dec14 FRA contract has started trading below the fixing, implying that there is a meaningful chance for a rate cut in December Norwegian Rates and EUR/NOK: Too much too soon? How fast will falling oil prices hit the Norwegian Economy? Soon according to current market pricing. We estimate that markets now price a 40% chance for a cut at the December meeting. Furthermore, the FRA strip is about 40bp below the rate path from next summer. Add to this that trade weighted NOK (I-44) is 6,5% weaker than Norges Bank is forecasting for June next year, something that would typically give a contribution of 65bp up in the rate path, and markets have discounted bad data worth a total of about down 100bp on the rate path. Domestic developments have been pretty much as expected since the last rate path was published in September, so it is only the disappointing global growth outlook and falling global markets, in particular the oil price, that has surprised to the downside. The question is whether markets have gone too far? We think this so, or at least too soon. As we have discussed in the previous section there are reasons to worry about the outlook for the Norwegian economy, but this is a medium term story and Norges Bank will allow itself time to see whether the worries materialise into something more than downside risk. The Dec14 FRA contract has started trading below the fixing, implying that there is a meaningful chance for a rate cut in December. The current fixing overlaps the meeting so it too is affected by the chances for a cut. We estimate that a neutral NIBOR fix today would be about 1.63%. Hence, Dec14 FRA at 1.52% implies that the short end is pricing 40% chance for a cut in December. The FRA settles after the December meeting and the next meeting takes place on 19 March, so the FRA will settle on the basis of the outcome of the December meeting alone, and not reflect the chance of a cut on a later meeting. As such, this contract offers decent risk/reward for expressing our too much, too soon view without being exposed for developments that increase the chances of a cut later next year. Chart 12: Market is 40bp lower than the rate path Chart 13: NOK much weaker than Norges Bank s forecast Source: Nordea Markets and Bloomberg 8

9 European FI Strategy Danish covered bond rates at Spanish levels Uffe Kalmar Hansen Senior analyst The consequence of having a highly liquid market is a very tight bid-offer spread Rates on Danish covered bond are now at the same levels as those observed on Spanish covered bonds (Cédulas). When assessing relative value this clearly seems counterintuitive, and in this context Danish rates look very cheap. Not only are Danish mortgages a fundamentally stronger credit, the relative strength of the Danish sovereign is a lot higher. On top of this comes the fact that the liquidity in the market is extremely high, with issuance (taps) taking place on a daily basis. The consequence of having a highly liquid market is that resulting in bid-offer spread is very tight, and a lot tighter than what we can observe for Spanish covered bonds. If we take bid/offer spread into account between the two markets, then the below graph would look even more skewed, and indeed make the Danish segment look even more attractive. The ECB has started to buy euro covered bonds with the reported figures being higher than expected. Together with the TLTRO we expect spreads and rates on covered bonds to tighten further. This will also have an impact on the Danish covered bonds. Chart 14. EUR/DKK and central bank intervention Chart 15: Danish mortgage rates 9

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