Reading the Markets Norway On track for a March hike

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1 Investment Research 18 February 2019 On track for a March hike Macro: Norges Bank appears determined to hike in March. Fixed income: expensive mid-segment s in ASW terms. NOK FX: utilise NOK setback to add longs; consider long vega strategies. New trades: Closed trades: Sell NST476 vs swap (reduced ASW spread). ASW spread barbell NST No closed trades Table 1. Danske Bank s market view in a nutshell Relative value Last update Stay or add long NOK exposure FX Steeper curve on wage inflation Curve view () Swap spreads (ASW) ASW-spread widening vs international peers Wider swap spreads vs international peers on growth Spread vs peers outperformance Steeper curve as market moving towards Norges Bank's Short-end [<2y] projections Norges Bank's policy rate 3m 6m 12m 1,00 % 1,00 % 1,25 % 4th issue 2019 targets our institutional fixed income and FX clients. It is produced biweekly. Strategy performance will be updated in future Reading the Markets Norway but strategies may be opened and closed in between reports. Chart 1. High ASW-spread in mid-segment s (476) -52 Chief Economist Frank Jullum fju@danskebank.no -47 NST 476 ASW Senior Analyst Kristoffer Kjær Lomholt klom@danskebank.dk Head of Fixed Income Research Arne Anders Lohmann Rasmussen arr@danskebank.dk Chief Strategist Jostein Tvedt jtv@danskebank.com Important disclosures and certifications are contained from page 8 of this report.

2 Oil-driven manufacturing recovery Strong industry sentiment indicators during the autumn have recently been confirmed by hard data. Norwegian mainland Q4 GDP at 0.9% q/q was driven by high activity in construction and broad-based manufacturing production growth. Private consumption is the main weakness at present. Real wage growth was marginal for 2018 as nominal wage growth at 2.8%, according to recent numbers from Statistics Norway, was only marginally above headline inflation at 2.7%. Core inflation for 2018 was 1.6%. That is, the slowdown in household consumption is to a large degree related to high electricity prices. Electricity prices will probably come down somewhat during the spring. This, together with a pickup in wage growth, should imply a recovery in household demand. Chart 2. Oil investment survey due 21 February Chart 3. Strong surveys confirmed by hard data Chart 4. Positive output gap Chart 5. Core inflation close to target On Thursday 21 February, Statistics Norway will release estimates for future investments in oil and gas, manufacturing and electricity supply, i.e. the investment survey. This is the first time the oil investment survey will also cover The survey is key for the business cycle outlook as well as providing vital input for Norges Bank s upcoming Monetary Policy Report 1/19, due 21 March. A survey number for 2020 at NOK should indicate a further healthy expansion of oil investments. Norges Bank s board meeting 21 March is only a month away. Neither the January board meeting nor the central bank governor s annual speech gave any indications that the Norges Bank board will deviate from the rate normalisation path outlined in the December Monetary Policy Report 4/18. In the annual speech, Olsen reiterated that the policy rate will be raised gradually and cautiously going forward if the economic development is in line with the bank s projections. In light of the recent strong domestic data and the current reduced geopolitical tensions, Norges Bank should be on track to hike as planned in March. That is, from 21 March, the sight deposit rate should be at 1.00%. The current NOK FRA 3M MAR19 is at 1.285%. Given an assumed spread between the 3M Nibor and the sight deposit rate of 35-40bps, the market does not currently fully discount a hike in March. The NOK FRA 3M DEC19 is as low as 1.48%, i.e. the market only marginally discounts above one hike during 2018 whereas Norges Bank guides towards two hikes. The spread between Norges Bank s projection and market expectations has become rather large. See Chart

3 Fixed income: too wide ASW spreads in mid-segment s Sell NST476 vs swap and wings given elevated ASW levels The mid-segment ASW-spread has widened markedly since December. The long-end asset swap spread has widened only moderately. After the NST474 auction last week the shortend has widen moderately, after an initial tightening. The spread widening is most pronounced for NST 476 (14 March 2024). We think the level at present is too elevated and suggest positioning for a tightening of the ASW spread of NST 476. The spread at present is 52bps. We suggest a P/L of 35bps/60bps. The reasons for the spread widening in the mid segment are mixed. The NST476 appears to enjoy some extra demand due to its status as the current five-year benchmark bond. Since 2014, Norges Bank has introduced a new 10-year government bond every year versus only every second year before Outstanding volume in the Norwegian bond market is governed by the Ministry of Finance s debt policy and is at present formally linked to the lending of the Government s special purpose guarantee and lending institutions. The limited and stable lending requirement implies that the total outstanding of bonds with maturity 2024 and later have an outstanding volume to the market that is only half of shorter bonds. This implies that the outstanding in the old five-year benchmark bond NST475 is significantly higher than for the current five-year benchmark NST476. See Chart 8. Therefore, benchmark related portfolio reallocations probably contribute to the current high AWS spread for NST476. The current strength of the Norwegian economy and the potential for a stronger NOK should attract increased demand for Norwegian government bonds going forward. It appears as if the mid segment currently enjoys a fair share of this extra demand. This midsegment focus may be temporary. The market is well aware that supply in the long-end will probably be ample at the end of the month due to the likely introduction of a new 10-year benchmark bond. See more below. As we have discussed before (12 November 2018 ), the Swedish Riksbank announced on 8 November that the bank would add DKK and NOK to its currency reserve during Q1 19. Total buying in the Norwegian market could be around NOK4bn in both bonds and bills, which is a significant amount for the Norwegian market. It is fair to assume that the Riksbank s buying is smoothed out over time, which suggests that it will contribute to keeping the ASW spread in the mid-segment elevated for some more weeks. Demand due to the Swedish Riksbank portfolio adjustment corresponds to approximately a third of a normal quarterly issuance. However, due to the likely syndication of the new 10-year benchmark bond, total supply will be somewhat more ample than normal in Q1 19. Introduction of a new 10Y benchmark in late Feb by syndication Norges Bank will most likely introduce a new 10-year benchmark government bond during last week of February. In late December, it informed the market of a potential syndication at this time. The auction calendar for February does not show any regular auction at the end of the month. Week 8 is the winter vacation on the east coast of Norway, which implies that week 9 is, basically, the only remaining alternative for the syndication. That is, we expect details about the auction relatively soon. Norges Bank indicated that in order to ensure good liquidity, the new bond s volume to the market will be built up fast, i.e. a total of NOK20bn to NOK30bn during 2019 versus total borrowing of about NOK50bn. The borrowing will typically be frontloaded in time. Chart 6. Market interest rate below Norges Bank s projection 2,70 2,20 1,70 1,20 0,70 Dec 13 Jun 15 Dec 16 Jun 18 Dec 19 Jun 21 Chart 7. Market discounts lower Nibor rates in 2019 than our forecast Chart 8. s outstanding to the market Source: Norges bank Historical 3m nibor Current market, 3m fwdnibor NB's 3m nibor MPR4/

4 The somewhat restricted increase in the asset swap spread in the long-end of the curve, relative to the mid-segment, can be seen in light of the market s anticipation of ample supply of long duration during the spring. However, the ASW spread of the mid-segment seems exaggerated relative to the asset swap spread in the long end. A low-risk alternative to the above strategy is to sell NST 476 (14 September 2024) and to buy NST 480 (26 April 2028) and NST474 (25 May 2021) versus swap. The ASW spread of NST476 is now -12bps wider versus the wings (barbell in bonds, butterfly in swaps). We suggest a P/L of -3bps/-20bps. Chart 9. Barbell NST vs swap: high ASW spread in mid-segment Chart 10. NOK vs EUR spread IRS 2Y/2Y 2,0 1,8 1,6 1,4 1,2 1,0 0,8 NOK IRS 2y/2y - EUR IRS 2y/2y ,6 Feb 13 Feb 14 Feb 15 Feb 16 Feb 17 Feb 18 Feb Chart 11. NOK FRA 3M SEP 19 vs SEK eq. still upside potential NST 476 ASW Barbell ASW-spread NST (rhs) Strategy review: stay exposed to higher Norwegian interest rates relative to peers In the 4 February RtM Norway, we recommended buying a NOK payer swaption due to the substantial upside potential for higher Norwegian interest rates if the geopolitical risk subsides in light of the strength of the Norwegian domestic economy. On the other hand, higher geopolitical risk, e.g. a failure in the ongoing trade negotiations between China and the US, could trigger a significant drop in Norwegian interest rates. We suggested buying a NOK PAYER SWAPTION 3M/5Y ATM. We still like this position, but the geopolitical risk appears to be somewhat reduced. This makes outright strategies for higher interest rates more attractive relative to using optionality. The weakness of the euro and Swedish economies implies that we refrain from most outright NOK strategies and prefer strategies for relatively higher Norwegian interest rates versus international peers. We suggest keeping open the strategy for a spread widening NOK IRS 2Y/2Y versus the euro equivalent. The spread has been stable recently. We opened the strategy at 164bps. The current spread is 166bps Spread NOK FRA 3m SEP19 vs SEK SEP Jan 23-Jan 30-Jan 6-Feb 13-Feb Chart 12. NOK FRA 3M SEP 21 vs DEC 20 too low a spread at the moment Spread NOK FRA 3m SEP21 vs NOK DEC In the 21 January RtM Norway, we suggested to be exposed for a spread widening NOK vs SEK FRA 3M SEP19. We opened the strategy at 140bps. After an initial positive development, the spread is back at the start. The strategy matches well our case of a growth outperformance of Norway versus Sweden and Norges Bank hiking according to own projections. 4

5 FX utilise NOK setback to add longs The NOK has suffered over the past weeks but we see the case of being long NOK as strengthened. Hence, we remain short EUR/NOK via options and long NOK/SEK spot outright. Clients wanting to increase exposure should utilise move lower in vol. In the last edition, we argued that foreign factors in the likes of USD- and SEK- selling had been crucial for sending NOK/SEK higher and EUR/NOK back into the 9.60s. We argued the move looked a little stretched and warned against a temporary setback. Admittedly, the recent setback has been larger than we anticipated. In our view, key to the move was temporary souring risk appetite and profit taking from foreign names. Also, short-end NOK rate spreads (EUR-NOK) have moved a little higher as illustrated by the top of Chart 13. Going forward, however, we still pencil in a stronger NOK. We have recently mentioned three key pillars for our call for a stronger NOK: (1) relative growth and relative rates, (2) structural liquidity and (3) global risk and oil prices. (1) This case is strengthened as the past weeks data releases on economic activity, employment and wage growth have all been clearly stronger than pencilled in by NB. Also the January inflation miss was more than likely temporary in nature as clothes prices are set to rebound. In that regard, the spread tightening to EUR rates seems wrong. Also the NOK is now 2.5% weaker than NB s forecast, which is a substantial positive factor for the rate path (+15-20bp) given how rate differentials to trading partners are higher (as foreign rates are lower) and since the oil curve is virtually unchanged from the December meeting. In addition, the implied Nibor-policy rate spread seems more narrowly priced than expected by the central bank, which in itself is another argument for a higher rate path. The only factor lowering the rate path at this stage is lower foreign rates but this will primarily have an impact from (2) We are now at a stage where structural liquidity has peaked and is set to tighten over the next three months. This has historically coincided with a stronger NOK and given how market forward pricing of the Nibor policy rate spread seems somewhat too tight given the outlook for tighter liquidity, this should underpin this argument for a stronger NOK. That leaves the final but important argument (3). After some loss of momentum, oil has once again moved higher (Chart 15). Risk appetite has levelled off a little on more sour trade negotiations news but we think that is a natural consequence of expectation management. In our view, Trump has too much at stake and we still expect a trade deal in coming months, which would be supportive of risk sentiment and the Chinese economy. Irrespective of the trade deal, we are already seeing early signs of stabilisation in China, see China Weekly Letter, 8 February. This is crucial for our call for a stronger NOK. As Chart 16 and 17 show, the G10 commodity currencies have traded remarkably synchronised with turning points coinciding with the Chinese cycle. If we are right on the Chinese cycle turning higher in Q2, it would support our short-term arguments for staying long NOK. In summary, we still like to be short EUR/NOK as the cleanest bet on a stronger tradeweighted NOK and long NOK/SEK as a play on the relative Scandi stories. Chart 13. Move lower in short-term NOK rates (red) helps to explain move lower in NOK Chart 14. Profit taking evident from the weekly Norges Bank flow data Chart 15. In recent weeks, oil prices have continued higher while NOK has moved lower Chart 16: A turn in China is set to Chart 17: support NOK and Com. FX. Chart 18. Implied NOK/SEK vol has fallen heavily making long-spot and long vega strategies attractive Source: Macrobond, Danske Bank Source: Macrobond, Danske Bank 5

6 Table 2. Open strategies and trades with recent status change Fixed income Sell NOK NST 476 (14 MAR Elevated ASW-spread driven of Opened 18-Feb ) vs swap demand ahead of long-end syndication Start -52 and limited outstanding in this new 5Y benchmark bond Target/stop '-35/-60 Now -52 P/L 0 Fixed income Buy NOK NST 480 (24 APR Exaggerated ASW-spread in the midsegment Opened 11.jan.19 vs wings (ref strategy 2028), NST474 (25 MAY 2021) Start -12 and Sell NOK NST 476 (14 opened 15 Oct) MAR 2024) X2 vs swap Target/stop -3/-25 Now -12 P/L 0 Money market Buy NOK payer SWAPTION 3M/5Y Potential for higher Norwegian Opened 4-Feb-2019 ATM % interest rate, if geopolitical risk Start 0,475 subsides and international downside outcomes do not materialise Target/stop Now P/L Money Market Buy NOK FRA 3m SEP19 sell SEK Too little hikes discounted for the Opened 11.jan.19 FRA 3m SEP19 NOK curve and too much for the SEK Start 140 curve for 2019 Target/stop 160/-130 Note: indications generally based on mid-market prices some hours ahead of the publishing of the report Now 138,5 P/L -1,5 Money market Pay NOK IRS 5Y/5Y and receive Norwegian growth outperformance Opened 11-Jan-2018 EUR IRS 5Y/5Y and increased wage growth Start 96,5 Target/stop 120/85 Now 110 P/L 13,5 Money Market Buy NOK FRA 3m JUN19 sell NOK The market discounts a too low Opened 10-Dec-2018 FRA 3m MAR19 probability of a hike during the Start 2,5 summer of 2019 Target/stop 15/-5 Now 4 P/L 1,5 Money market Buy NOK FRA 3m JUN19 outright The market discounts a too low Opened 10-Dec-2018 probability of a hike during the Start 1,32 summer of 2019 Target/stop 1,5/1,25 Now 1,325 P/L 0,5 FX Short EUR/NOK via 3M Utilise year-end weakness to position Opened 4-Dec :1:2 seagull for NOK move higher in 2019 Start 9,6918 Target/stop N/A Now 9,7691 P/L 0,10 % New New Take profit 6

7 Table 3. Open strategies and trades with recent status change FX Buy NOK/SEK spot outright Position for fundamental growth and Opened 4-Dec-2018 wage differences between Norway Start 1,0569 and Sweden Target/stop 1.40/ Note: indications generally based on mid-market prices some hours ahead of the publishing of the report Now 1,0729 P/L 1,80 % Money Market Pay NOK IRS 2Y2Y and receive EUR Market still below NB guiding. The Opened 4-Dec-2018 IRS 2Y2Y both vs 6M guiding probably will be reiterated in Start 164 the upcoming MPR 4/18. Relative version of 26 Nov strategy Target/stop 195/145 Now 166 P/L 2 Fixed income Buy NST 480 2% 4/28 and Relative outperformance on limited Opened 4-Dec-2018 sell DBR 0.5% 2/28 issuance Q and demand from Start 157 strong NOK outlook Target/stop 140/165 Now 165 P/L -8 Money Market Pay NOK IRS 2Y2Y outright Market still below NB guiding. The Opened 26-Nov-2018 Stop guiding probably will be reiterated in loss late Start 2,09 the upcoming MPR 4/18 Dec Target/stop 2.40/1.90 Now 1,9 P/L -19 Money Market Buy NOK FRA 3m SEP21 and sell Steeper NOK green FRA curve as Opened 29-Oct-2018 NOK FRA 3m DEC20 market buys into the NB Start 15 normalisation process Target/stop 35/0 Now 10 P/L -5 Fixed income Wider ASW-spread 10Y benchmark Increased ASW-spread NST480 Opened 15-Oct-2018 relative to German equivalent: "Risk Start -34 on", strong-nok-trend generated demand for and increased payer Target/stop -43/-29 interests in swaps Now -38 P/L 4 Fixed income Buy NST Apr 2028 in Increased ASW-spread NST480 Opened 15-Oct-2018 an ASW-box vs Germany relative to German equivalent: "Risk Start 15 on", strong-nok-trend generated demand for and increased payer Target/stop 0/22 interests in swaps - relative to Now 22 international peers P/L -7 Money Market Pay NOK IRS 2Y3Y outright Market still significantly below NB Opened 1-Oct-2018 guiding and NB may upward revise the real interest rate estimate Start 2,3 Target/stop 2.65/2.15 Now 2,15 P/L -15 Stop loss 15 Jan Stop loss late Dec Stop loss 29 Nov 7

8 Disclosures This research report has been prepared by Danske Bank A/S ( Danske Bank ). The authors of the research report are Frank Jullum (Chief Economist), Arne Anders Lohmann Rasmussen (Head of Fixed Income Research), Jostein Tvedt (Chief Strategist) and Kristoffer Kjær Lomholt (Senior Analyst). Analyst certification Each research analyst responsible for the content of this research report certifies that the views expressed in the research report accurately reflect the research analyst s personal view about the financial instruments and issuers covered by the research report. Each responsible research analyst further certifies that no part of the compensation of the research analyst was, is or will be, directly or indirectly, related to the specific recommendations expressed in the research report. Regulation Danske Bank is authorised and subject to regulation by the Danish Financial Supervisory Authority and is subject to the rules and regulation of the relevant regulators in all other jurisdictions where it conducts business. Danske Bank is subject to limited regulation by the Financial Conduct Authority and the Prudential Regulation Authority (UK). Details on the extent of the regulation by the Financial Conduct Authority and the Prudential Regulation Authority are available from Danske Bank on request. Danske Bank s research reports are prepared in accordance with the recommendations of the Danish Securities Dealers Association. Conflicts of interest Danske Bank has established procedures to prevent conflicts of interest and to ensure the provision of high-quality research based on research objectivity and independence. These procedures are documented in Danske Bank s research policies. Employees within Danske Bank s Research Departments have been instructed that any request that might impair the objectivity and independence of research shall be referred to Research Management and the Compliance Department. Danske Bank s Research Departments are organised independently from, and do not report to, other business areas within Danske Bank. Research analysts are remunerated in part based on the overall profitability of Danske Bank, which includes investment banking revenues, but do not receive bonuses or other remuneration linked to specific corporate finance or debt capital transactions. Financial models and/or methodology used in this research report Calculations and presentations in this research report are based on standard econometric tools and methodology as well as publicly available statistics for each individual security, issuer and/or country. Documentation can be obtained from the authors on request. Risk warning Major risks connected with recommendations or opinions in this research report, including as sensitivity analysis of relevant assumptions, are stated throughout the text. Expected updates Bi-weekly Date of first publication See the front page of this research report for the date of first publication. General disclaimer This research report has been prepared by Danske Bank A/S. It is provided for informational purposes only and should not be considered investment advice. It does not constitute or form part of, and shall under no circumstances be considered as, an offer to sell or a solicitation of an offer to purchase or sell any relevant financial instruments (i.e. financial instruments mentioned herein or other financial instruments of any issuer mentioned herein and/or options, warrants, rights or other interests with respect to any such financial instruments) ( Relevant Financial Instruments ). The research report has been prepared independently and solely on the basis of publicly available information that Danske Bank considers to be reliable. While reasonable care has been taken to ensure that its contents are not untrue or misleading, no representation is made as to its accuracy or completeness and Danske Bank, its affiliates and subsidiaries accept no liability whatsoever for any direct or consequential loss, including without limitation any loss of profits, arising from reliance on this research report. The opinions expressed herein are the opinions of the research analysts responsible for the research report and reflect their judgement as of the date hereof. These opinions are subject to change and Danske Bank does not undertake to notify any recipient of this research report of any such change nor of any other changes related to the information provided herein. This research report is not intended for, and may not be redistributed to, retail customers in the United Kingdom or the United States. This research report is protected by copyright and is intended solely for the designated addressee. It may not be reproduced or distributed, in whole or in part, by any recipient for any purpose without Danske Bank s prior written consent. 8

9 Disclaimer related to distribution in the United States This research report was created by Danske Bank A/S and is distributed in the United States by Danske Markets Inc., a U.S. registered broker-dealer and subsidiary of Danske Bank A/A, pursuant to SEC Rule 15a-6 and related interpretations issued by the U.S. Securities and Exchange Commission. The research report is intended for distribution in the United States solely to U.S. institutional investors as defined in SEC Rule 15a-6. Danske Markets Inc. accepts responsibility for this research report in connection with distribution in the United States solely to U.S. institutional investors. Danske Bank is not subject to U.S. rules with regard to the preparation of research reports and the independence of research analysts. In addition, the research analysts of Danske Bank who have prepared this research report are not registered or qualified as research analysts with the NYSE or FINRA but satisfy the applicable requirements of a non-u.s. jurisdiction. Any U.S. investor recipient of this research report who wishes to purchase or sell any Relevant Financial Instrument may do so only by contacting Danske Markets Inc. directly and should be aware that investing in non-u.s. financial instruments may entail certain risks. Financial instruments of non-u.s. issuers may not be registered with the U.S. Securities and Exchange Commission and may not be subject to the reporting and auditing standards of the U.S. Securities and Exchange Commission. Report completed: 15 February 2019, 15:26 CET Report first disseminated: 18 February 2019, 06:45 CET 9