European FI Strategy Low enough yet? Nordea Research, 25 June 2014

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1 first FI Strategy European FI Strategy Low enough yet? Nordea Research, 25 June 2014 Global markets The ECB delivered completely in line with our expectations, and the low for longer regime is back perhaps stronger than ever before. Inflation is the key for the ECB, and the prints coming the next 3-6 months are vital for rate direction and future ECB policy. The story is different across the Atlantic where wage pressure potentially can cause the Fed to embark on a hike path sooner rather than later. EUR Strategy We didn t go negative on Eonia fixings (1bp was the recent global low), and with excess liquidity rising less than anticipated, it looks like negative fixings at the very earliest can arrive after take-ups on the TLTROs, and there it doesn t look likely without further ECB easing. The Eonia curve is historically low and flat, and steepeners look interesting in the very front. The long end of the curve still looks favorable for roll/carry trades, and there are several opportunities in vol space. Sweden Cut on July 3 rd looks a done deal, and a dovish one at that meaning that the Riksbank likely has to revise its rate forecasts down afterwards. Should this happen, another cut could well be priced in for the autumn and as such, SEK steepeners looks attractive. Norway Norges bank surprised in recent dovishness, opening the door for a cut later this year. A steeper FRA curve looks like an attractive position at this time. Denmark After two hikes (one explicit and one implicit), DKK rates have widened strongly over EUR. Danish risk is starting to look very cheap. Chart of the month: EUR/USD spread large, but may well continue 7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% swap rate 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 Global Markets EUR Strategy... 4 Scandi corner Swedish rates... 6 Scandi corner Norwegian rates.. 7 Scandi corner Danish rates...8 USD 2y2y EUR 2y2y spread (r.a.)

2 Jan von Gerich Chief Analyst Fixed Income jan.vongerich@nordea.com Despite a very dovish central bank and subdued rates, there are also upside risks out there. Rates have risen quite rapidly several times also in the post financial crisis world. Global Markets Overview Do not forget the upside risks In light of the ECB s pledges to keep rates low for even longer and very subdued yield levels, it would be easy to succumb to the idea that if rates move somewhere, it is further down, period. Still, there are plenty of triggers that can cause sizable moves in interest rates if not in the very short end of the curve, at least longer out. Although we do not see rapidly rising rates ahead, it makes sense to discuss some of the upside risks, especially ahead of the summer, when trading volumes fall and large moves are very possible. For the ECB, inflation is clearly the key, but the central bank is not going to change course easily, in either direction. The outlook would have to change materially for the ECB to embark on further stimulus, or turn more hawkish. That said, market expectations are for very subdued inflation prints to continue. Even if inflation pressures are not about to pick up materially any time soon, upside surprises are certainly possible, in which case the markets could easily conclude more stimulus is not on the table any more. On the other side of the Atlantic, or the Channel for that matter, the situation looks quite different. Inflation pressures are gradually building in the US, and rising inflation coupled with increasing wage pressures could easily persuade the Fed to change course. Higher US rates would put upside pressure on especially longer EUR yields as well, while a weaker euro would help to lift Euro-zone inflation and boost also the Euro-zone economy. The market action from the past few year s acts as a reminder that also in the post financial crisis world, rate rises can take place rapidly and be rather substantial. In late 2008 early 2009, the US 10-year yield roughly doubled from 2% to 4% in less than six months, driving EUR yields clearly higher as well. In late 2010 / early 2011, the German 10-year yield rose by almost 150bp, as growth picked up, rising oil prices lifted inflation and the Eurozone crisis showed signs of easing. Finally, the US 10-year yield jumped by almost 150bp last year, as the market started fretting about Fed tapering. Other scenarios of higher (long) rates include stronger global growth coupled with a weaker euro and higher commodity prices, or change of focus from low inflation and high unemployment to more positive sentiment indicators (for more on the topic, please see here). Chart1. Also sell-offs can take place rather quickly Chart 2. Inflation expectations already quite low 2

3 Jan von Gerich Chief Analyst Fixed Income jan.vongerich@nordea.com Spread narrowing to continue despite higher volatility. In semi-core names, Belgian and 10-year French spreads with most narrowing potential. Lars Peter Lilleøre Chief Analyst IR Products lars.peter.lilleore@nordea.com Long end steepeners have performed, but still value in forward versions Eonia curve flat and low. Best value now in front end steepeners EUR Strategy Tighter for the summer Spread narrowing has mostly continued in the aftermath of the ECB s easing package. However, the volatility has increased in the past few months, illustrating increasing temptation to take some profits after several years of narrowing spreads. The increased volatility can be seen in a positive light, as it can also offer more attractive entry levels. As the ECB has made it clear rates are going to remain low for years, the incentives to search for carry have gotten even stronger. Even though higher volatility is set to continue over the summer, we see upward corrections in spreads as buying opportunities and expect the trend of narrower spreads to continue. Looking at Italian and Spanish bonds, the 5-year sector has performed a lot vs. Germany, while 10-year bonds have lagged to some extent in the rally. As spreads narrow, it looks increasingly attractive to move further out the curve to find pick-up, which should support also the 10-year sector. In the semi-core names, we see best narrowing potential in Belgian spreads vs Germany, while also French 10-year spreads look rather wide compared to the levels prevailing in the 5-7-year part of the curve. Levels and curves: To stay put or to revert? The number one decision right now for investors: Will we correct/revert from the current pricing, which in many aspects is extreme from a historical perspective, or should we gear up on roll/carry positions as we brace ourselves for 2-3 years more of low-for-longer? Quite unfortunately, there s no obvious answer to this question, but for the time being given that we re facing a period where the ECB initiatives from June will be rolled out roll positions are interesting. The obvious candidates are 5s30s and 10s30s forward steepeners which still entail strong roll, but at the same time have steepened quite a bit post-ecb. Given the recent vol movements, such trades are also cheap to enter in swaptions. In the front of the curve, Eonia s are now priced less aggressive than directly after the ECB. Whereas the risk reward earlier clearly was for paying e.g. 6M6M outright (those remain low, but have corrected upwards), we now see the best value in steepening structures on the Eonia swap curve, e.g. 1y1y v which is a historically depressed risk premium. Chart 3. 10Y sector lagged 5Y in spread narrowing Chart 4: Eonia levels and slopes in the hole 3

4 Lars Peter Lilleøre Chief Analyst IR Products Vol term structures are now historically steep and recent pricing has been perhaps too adaptive Positions aimed towards reversing shocks often turn cheap in the option market. You just have to look for them. EUR vol levels, vols and correlation Contrarily to common wisdom less risky than swaps Over the past month, implied vols on EUR swap rates registered all-time low levels even for expiries as relatively long as 2Y. This happened in the aftermath of the ECB package on June 5 th, and the 2Y2Y straddle got as low as 86bps, and all-time cheap price for that asset. The dynamics here are straightforward; rates re-price on the ECB (from inflation outlook) and register a close to 1:1 effect onto implied volatilities. This is certainly the case for optionality on 2Y rates with its close liaison to the ECB. A related aspect is a strong steepening of the vol term structure, with e.g. 4y2y-2y2y registering all-time highs recently. Another distinct feature of the recent pricing goes on a rather extreme adaptive pricing. In essence what just happened is taken to be likely to continue to happen, at least to a certain extent. For instance, after the ECB, the 5Y point got hammered the most on the EUR swap curve, and due to the high correlation mentioned above, this meant that 3m5y vol followed this movement down and generating a rather huge gap to 3m10y. This type of move typically reverts, at least partly, when some of the dust settles, even if rates don t rebound significantly. A concrete example of this is given below in chart 6. As rates dropped post- ECB, 5s10s steepened quite aggressively, but at the same time and pace, 3m5y vol cheapened relative to 3m10y vol, i.e. the forward looking vol adapted almost completely to the realised vol, relatively speaking. One week after, the bpvol spread reached a high with 12bpVol in difference between 3m5y and 3m10y vol and did so at the same time as 5s10s on the swap curve maximised. Now naturally, it is difficult to say in advance when and where these curves top, but note that the reverse position to the realized movement the 5s10s flattener gets cheaper and cheaper to enter conditionally on rising rates during this. Chart 5. Vol term structure on 2Y tails at an all-time high Chart 6. Adaptive pricing, mistakes being made 4

5 Draghi, ever the dove, implicitly lowers implied correlations By 2017, by how many hikes do the ECB trail the Fed? Current market pricing should be associated with quite low correlations. It s not, and wedges looks interesting. Mind the wedge The correlation referred to above is (local) realized correlation. Another type of correlation has gotten re-priced as well, namely that of implied correlation. When the ECB gets re-priced, and furthermore when Draghi himself is out saying that prolonging bank s access to unlimited liquidity up to the end of That is a signal, then a regime of high certainty prices the very front of the vol term structure down, but leaves the longer-dated contracts reasonably elevated. For illustration, take Draghi s words literal and assume that for the next 3 years we ll remain low and in a tight range, and then infer that a rather aggressive hike cycle will take place after this with the ECB trying to catchup with the Fed. In this scenario the correlation between Euribors in year 1 and Euribors in year 4 should be implied low as the latter will increase strongly whereas the former will be steady. That sounds quite a lot to us like the current market mantra. The price of the correlation can be deduced by looking at relative pricing between the swaption and cap/floor markets. If implied correlation is very high, the wedge between these will be small, and conversely, if it s small, the gap will be high. Given the above, we d expect the latter. However as chart 7 illustrates, this is not the case currently. In fact, the 4x6 vs. 4y2y straddle wedge is in 28bps, over 20bps below the recent top in mid With the ECB outlook, we d find this an attractive level for buying (i.e. buying 4x6 cap/floor straddles vs. 4y2y swaption straddles) on its own, but the attractiveness increases with the observation that sell-offs very likely will ensure a profit as the market begins to scale down on the perceived certainty, as was the case several times in 2013, cf. again chart 7. Chart 7: A few years out, wedges look cheap straddle premiums wedge (in bps) x6 4y2y wedge (r.a.) Source: ICAP and Nordea Markets 5

6 European FI Strategy Scandi Corner Fredrik Floric Chief Analyst fredrik.floric@nordea.com Rate path could be revised lower by as much as 80100bps, which would be a very dovish signal Swedish rates: Prepare for a dovish cut There is one key event left in Sweden, the 3rd July Riksbank rate announcement, before heading into the typical July summer lull. The main happenings since the previous decision in April can be summarized by; inflation surprising somewhat on the downside again, ECB having cemented low-for-long further, and most recently, Norges Bank being much softer than unanimously expected. These are the key issues the Riksbank needs to tackle, and from a strategy perspective it looks lined up for a dovish message. Indeed, we expect the bank to cut by 25bps, but in order to re-gain credibility, a sharp adjustment lower of the rate path is also necessary. The easiest way to illustrate the need for such a revision is to compare the current rate forecast with the messages by ECB and Norges Bank, central banks that are highly central for the policy setting. As chart 8 shows, the Riksbank base-line scenario is now for an unprecedented decoupling vis-àvis ECB, to levels that haven t been seen previously, even with inflation well above the 2% target. On a similar note, figure 2 shows that the relationship with Norges Bank looks equally, if not more, obsolete. This simply tells us that, besides the much anticipated rate cut, the bank also needs to revise the rate forecast substantially lower and likely also pencil in a near-term easing bias. As we see it, there is scope for a downward revision in the magnitude of bps for , which would be a very dovish signal. In markets, such a message would likely trigger further speculation of another move down towards 0.25%, but it will indeed also be seen as an encouraging fact for front-end receivers against euro rates. It will cement the very front-end further and isolate it against a move higher in global yields over the summer, leaving the curve even more directional to longer tenors than before. As such, steepeners in Sweden could be an attractive pick for those anticipating a weaker bond climate globally over the summer. In this perspective, the 5yr part of the curve should prove most fragile, with 2yr2yr forward rates at round all-time lows (just like EUR) and yield curve convexity fully decoupled with the likes of USD and GBP markets.. Chart 8. Riksbank vis-à-vis ECB Chart 9. Riksbank vis-à-vis Norges Bank 6

7 Gaute Langeland Chief Analyst Central bank puts large emphasis on weak forecasts Little room for further outperformance of the 5yr caused by low 2s5s10s butterfly Significant flattened FRA stip over the past months Norwegian Rates: Go for steeper FRA curve Norges Bank was surprisingly dovish at the meeting last week. They opened the door for a cut later this year. Although this is not the base case it indicates that the risk for the policy rate is skewed to the downside and that a hike is a long way off. The main surprise was the emphasis the central bank put on weak forecasts for investments in the petroleum sector next year since these forecasts are subject to large revisions. This hugely important sector is definitely no longer the major growth engine it was in the years prior to 2013, but it was surprising that the central bank already now pencilled in a 10% drop for 2015 given the large revisions these forecasts are subject to. A possible rate cut is some way off so the very front end of the curve is anchored by the current policy rate. This meant that the 5yr sector sharply outperformed the rest of the curve as rates fell on the new rate path. The front end of the curve flattened while the back end of the curve steepened. The 2s5s10s butterfly is now so low that the 5yr sector has little room for further outperformance (see chart 10). The 2s5s10s butterfly has even fallen relative to the European equivalent. Given the level of the fly, it seems interesting to position for a move higher. However, carrry for paying 5yr vs the wings is prohibitively expensive at approx 25bp/yr so investors need to look for more carry efficient alternatives. From chart 10, it is obvious that the main move behind the richening of the 5yr has been a flattening of the front end of the curve, not a steepening of the back end. As such, steepeners in the front end attractive. The FRA stip has flattened significantly over the past months. It should of course steepen on a move higher in rates, but if we go far enough out on the strip it also has the potential to steepen on a move lower in rates if this happens in conjunction with (firm expectations of) a rate cut. Given that the calendar spreads in the reds are close to multi year lows and roll is low, steepeners here stands out as attractive. We like the Jun15/Dec15 steepener (4 th vs 6 th contract) at 6bp. Chart 10: 5yr sector has outperformed sharply Chart 11: We like steepeners in the red FRAs Source: Nordea Markets and Bloomberg Source: Nordea Markets and Bloomberg 7

8 Niels Blixenkrone Chief Analyst Danish bonds have taken a beating in the aftermath of Nationalbanken s hike and Draghi s cut. Substantial issuance in the DKK 10y segment in combination with semi-core performance leaves Denmark an attractive alternative at current levels Danish rates: Denmark after the cut has the dust settled? While the effect on EURDKK was somewhat muted in the wake of the relatively large 15bps hike from Nationalbanken in April, we have seen a substantial appreciation of DKK in the wake of the ECB cut in early June. The two relative hikes have been accompanied with a stark widening of the fixing-spread. We even saw increasing Cibor fixings after the ECB cut as the market had factored in some possibility that Nationalbanken would follow suit. It is worth noting that the move in relative rates has not been enough to pull FX fwds into positive territory due to a still high (and stable) FX basis. This means that EUR based investors rolling FX swaps are still able to secure a positive FX related contribution of some 10bps on top of their DKK bonds. 6-9m FX swaps look the best. On the xccy basis curve DKK basis has actually become further negative lately while bases on most other currencies has widened against EUR. We eye a buying opportunity: Further out the curve we have seen a waning demand for 10y DKK bonds in combination with efforts from the Nationalbanken to build liquidity in the new DGB25. On that note, the Nationalbanken has just revised the target up from DKK 75 to 100bn for 2014 (proceeds of DKK 58,1bn have been ensured YTD). Chart 12 suggests that IRS is still the cheapest way of getting Danish exposure, but after the recent widening cash based investors can now buy the AAA rated DGBs at a yield pick-up of some 16 bps to Germany which begins to look like an attractive alternative to other semi-core markets (even excluding xccy basis) cf. chart 13. We still favour being long Denmark through IRS, but see the DGB23/25 as a top picks on the Danish curve. They offer the best roll and carry, and the issuance premium in the DGB25 looks fair. The stronger DKK has wiped the slate clean in terms of more hikes and even led to discussions of a Danish cut somewhere down the road. It might be too soon to claim that Denmark has weathered the storm but we believe it is time to do the first clip now Chart 12. DGB, DBR, DKK IRS and EUR IRS Chart 13. Yield pick-up to Germany DK and peers 8

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