Swedish Rate Wrap. Riksbank expands QE inflation-linked bonds are added to the shopping basket. The Riksbank acts pro-actively again.

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1 February 8, 2016 Trading Strategy Swedish Rate Wrap Riksbank expands QE inflation-linked bonds are added to the shopping basket Chart 1: Relative balance sheets and EURSEK The Riksbank acts pro-actively again Once again, the Riksbank will need to take a stand on what the ECB might do in the future. A reasonable assessment is that the ECB will expand its monetary stimulation measures in conjunction with its March meeting. Our conclusion is that the Riksbank s bond purchases will be extended for the rest of the year by a further SEK 50b and that inflation-linked bonds are to be included in the purchases. The interest rate will be left unchanged, however. We discuss the arguments on page 3. Source: Macrobond and Handelsbanken Capital Markets Claes Måhlén: clmak02@handelsbanken.se Andreas Skogelid: ansk03@handelsbanken.se Lars Henriksson: lahe06@handelsbanken.se Pierre Carlsson: pica01@handelsbanken.se Our outlook in a nutshell Kort Duration Kurva Bostäder Krediter Neutral Lång Source: Handelsbanken Capital Markets For full disclaimer and definitions, please refer to the end of this report.

2 Swedish Rate Wrap, February 8, 2016 Market in brief Duration Curve Short end Sweden vs. Germany Mortgages Swap spreads Credits Neutral. Neutral. Higher short-term Swedish interest rates. Widening at the short end of the curve. Long, attractive levels. Down on the long side. Neutral. 2

3 Swedish Rate Wrap, February 8, 2016 Our outlook The year s first monetary policy decision by the Riksbank is close (February 11). Once again the Riksbank faces challenges: global financial volatility, concerns about the global business cycle, a lower oil price compared with the December meeting and a radical re-pricing of future Fed rates. In addition to these considerations, we see low domestic inflation figures and changed expectations of central banks worldwide. The market is now pricing in less than one rate hike from the Fed during 2016, compared with around 2.5 at the time of the Riksbank s December meeting. In addition, there are high expectations that the ECB will move its monetary policy in a more expansive direction in March, which can be considered as the main argument for additional measures from the Riksbank. At the same time, the Swedish economy continues at full speed. During the spring, the market is pricing in a repo rate at least 10bp lower than today s level (chart 2). The market s view of the future repo rate then starts to diverge compared with the Riksbank s repo rate path. Regarding the tool(s) to be used by the Riksbank, it is important to remember that the primary purpose of the measures is to avoid an excessively strong Swedish krona. The Swedish economy has no need of additional monetary stimulus. A lower repo rate would reduce short-term mortgage rates, at least on the margin. From the Riksbank s perspective, this would be an unwelcome consequence. Currency interventions are also an alternative, but these seem unlikely at present since the trade-weighted krona index is close to the Riksbank s forecast. Currency interventions will be used if the krona strengthens quickly, but not as a monetary policy measure in conjunction with a normal monetary policy meeting. Chart 2: Market pricing repo rate Source: Bloomberg Chart 3: Relative balance sheets and EURSEK Source: Macrobond and Handelsbanken Capital Markets Chart 4: Foreign ownership of government bonds What remains therefore, is an expansion of the balance sheet via additional bond purchases (Chart 3). An extension of the Swedish bond purchase programme would counteract the pressure for a stronger krona against the euro given that the ECB will continue to expand its balance sheet up to at least the end of March The bond purchases previously advised by the Riksbank will continue until the end of June An increase of SEK 50bn for the rest of 2016 would effectively neutralise the impact of the ECB s expanding balance sheet. Source: Macrobond and Bloomberg 3

4 Swedish Rate Wrap, February 8, 2016 So far, the Riksbank has bought nominal government bonds for SEK 148bn and holds 24percent of the outstanding volume. This figure will have increased to about 33 percent by the end of June Since bond purchases were initiated at the end of February 2015, international investors have reduced their holdings of government bonds from around 50 percent to about 38 percent in November 2015 (Chart 4). This corresponds to a decrease of about SEK 90bn, which is not at all matched by international investors increases elsewhere, such as mortgage bonds. It therefore seems reasonable to assume that these investments have partly left the country, resulting in increased selling pressure on the krona, in line with the Riksbank s wishes. The Riksbank pays well for the bonds it purchases and, so far at least, has not had any difficulties attracting material to the auctions; offer to cover has often been between two and four. Chart 5: Volume of nominal government bonds (SEK) Source: Macrobond and Bloomberg Chart 6: Breakeven inflation and oil Our main scenario is that the Riksbank expands the QE programme by SEK 50bn up to year-end. If the Riksbank continues to buy only nominal government bonds, it will increase its holding to 40 percent and the volume of bonds available for the rest of the market will decrease further. This would have a negative impact on the government bond market. Since the Riksbank started its bond purchases, liquidity measured as the daily turnover of nominal government bonds has not been significantly affected (Chart 5), except at the start of Seasonally, liquidity declines during the summer months, but the low turnover seen during January is unusual. To reduce the negative effects of the bond purchases, it is reasonable for the asset class to be expanded to cover additional types of bonds. Mortgage bonds (covered) represent a large, liquid market. However, we rule out the possibility that the Riksbank would enter this market because by doing so, it would push mortgage rates lower and indirectly pour additional fuel on to increasing housing prices. Municipal bonds represent another alternative. However, how these purchases would be weighted in a competitivelyneutral manner is not completely obvious. Municipalities/county councils/organisations which the Riksbank buys would risk receiving favourable treatment at the expense of others a not entirely successful spin-off effect. What remains is government inflation-indexed bonds and these are our main alternative for expansion. This is certainly a smaller market than for the nominal bonds with just over SEK 165bn outstanding, primarily with long maturity periods. However, in the future as Source: Bloomberg, Riksbank and Handelsbanken Capital Markets Chart 7: Breakeven inflation forward curve Source: Bloomberg and Handelsbanken Capital Markets 4

5 Swedish Rate Wrap, February 8, 2016 well, the Riksbank will keep bond purchases clean and only buy Swedish government bonds, while ensuring that its increasing share of nominal bonds is moderated. Foreigners may also take part in the auctions, which could increase selling pressure on the krona an undesirable effect. During the recent period of declining interest rates, it is mainly breakeven inflation which has fallen while the decline in real interest rates has been more modest (Chart 6). We think that inflation-indexed bonds appear attractive compared with nominal bonds. Break-even inflation is being traded at the lower end of the past year s interval and at least for the moment, does not reflect the latest rebound in the oil price. In forward terms, the entire curve is trading at breakeven levels below the inflation target. If the Riksbank were to increase the bond purchase programme to include inflation-indexed bonds, this would also push real interest rates down. To sum up, our conclusion is that the Riksbank will keep the repo rate unchanged at its meeting next week. The repo rate path will almost certainly be delayed so the first increase will be later than July The Riksbank will indicate that the interest rate can be lowered further. However, what the Riksbank does with the repo rate in the future is dictated by what the ECB does with its deposit interest rate. The QE programme will be expanded by SEK 50bn and will run to year-end, giving a total volume of SEK 250bn. We believe that some of the expansion will include inflation-indexed bonds. 5

6 z cc Swedish Rate Wrap, February 8, 2016 The Riksbank at a glance Inflation barometer Inflation (CPIF) and forecasts Green +2; Red -2 standard deviation from consensus forecast, yearon-year change versus historical average Source: Macrobond, Handelsbanken Capital Markets Source: Macrobond, Riksbank and Handelsbanken Capital Markets The Riksbank s repo rate forecast and the market Meeting Market Riksbank (Dec) Market vs Riksbank Dec Feb Apr Jul Sep Oct Dec Feb Apr Jul Sep Oct Dec Feb Apr Jun Aug Oct Dec Swedish macro data vs. consensus forecast Source: Bloomberg, Handelsbanken Capital Markets Source: Riksbank and Handelsbanken Capital Markets Summary The National Institute of Economic Research (NIER) manufacturing index increased to its highest level on record in January. Consumer confidence was more or less flat. Industrial production, for December, was much weaker than expected resulting in an annual growth rate barely above zero. Moreover, the unemployment rate and retail sales were been weaker than expected for December. On the positive side, the service production which rose six percent in

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