Reading the Markets Sweden

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1 Investment Research 1 March 219 Why are European yield curves not steepening? We propose an alternative to 3Y-1Y swap steepeners that we hope is less exposed to the global hunt for yield. Consumers see higher mortgage rates. Swedish GDP conceals falling domestic demand. What does GDP tell us about the Riksbank? Relief for the SEK. Trades New, as an alternative to 3Y-1Y swap steepeners, buy SHYP1588 (Mar 224) versus SGB161 (Nov 229). Start: 14bp. P/L: 4/21bp. Danske Bank s market view in a nutshell Relative value Grade * Last change Fear of a recession may be overdone - rates could bounce higher Delta in the coming months. 2 24/1-219 Curve view Steeper curve SEK 3Y-1Y. 3 24/1-219 Cross country sprds Neutral. 1 24/1-219 Short-end (<2Y) Receive FRA SEP19 outright. 3 1/1-219 Index-linked bonds Steeper 5y/1y real rate curve. 3 29/ Covered bonds Buy 3Y covered bonds vs swaps. Buy 5Y covered vs 1Y SGBs. 3 28/2-219 Swap Spreads Buy Kommuninvest K241 ASW. 3 2/7-219 SEK Stay long NOKSEK. 3 28/2-219 Repo rate 3m 6m 12m -.25% -.25% -.25% * Grade of conviction 1-3, where 3 = strongest Source: Danske Bank Chief Analyst Michael Boström mbos@danskebank.se Chief Economist Sweden Michael Grahn mika@danskebank.se FI Strategy Carl Milton carmi@danskebank.se FX Strategy Stefan Mellin mell@danskebank.se Important disclosures and certifications are contained from page 12 of this report.

2 Why are European yield curves not steepening? In contrast to our expectation, the curve has continued to flatten gradually since we initiated our recommendation to steepen SEK 3Y-1Y swap. Admittedly, European industrial data has remained on a worrying trend. However, we noted in, 22 February, other risky assets have jumped significantly higher, especially equity markets. Longer German and Swedish government rates continued to hover around lows for most of February, after falling drastically since early October. We suspect that some other factors may be at play as well. In particular, the flatness of the US Treasury curve may increase demand for European assets. As shown in the chart below, the USD curve flattening in conjunction with rate hikes/qe wind down has meant that the cost of hedging the FX exposures eats up most of the yield pickup foreign investors can receive in the 1Y point. Cost of FX hedging eats up yield pickup in Treasuries for foreign investors USGOVT Implied USD FX depo rate Source: Danske Bank, Bloomberg feb-19 jul-24 jan-3 jul-35 dec-4 jun-46 dec-51 Instead, there are indications that global investors have been looking elsewhere for a yield pickup. For instance, Japanese investors have on a net basis stopped buying USD assets and have increased holdings in (among other) EUR/DKK/SEK assets. We suspect other global asset managers have similar incentives. Indeed, when we factor in the cost of FX hedging, Bunds (and especially semi-core markets such as France) no longer look as expensive on a relative basis. Japanese investors have stopped net buying of USD bonds and have increased holdings in EUR Net purchase of US LT debt securities, USD bn Net purchase of EU LT debt securities, USD bn feb-14 sep-14 apr-15 nov-15 jun-16 jan-17 aug-17 mar-18 okt-18 Source: Ministry of Finance (Japan), Bloomberg feb-14 sep-14 apr-15 nov-15 jun-16 jan-17 aug-17 mar-18 okt-18 Source: Ministry of Finance (Japan), Bloomberg 2 1 March 219

3 Conveniently, this shift in global investor preference would also explain the move in EURUSD CCS, where the relative demand for USD funding has fallen sharply. It would also be consistent with the stubbornly high SEK 3M fixings as larger holdings of SEK bonds for real-money investors could go hand in hand with regular demand for FX hedges. This would explain why the relative cost of swapping 3M USD Libor (in itself on a downward trend) continues to imply a relatively high 3M Stibor. Although we continue to believe that current fixing spread levels are toppish, the downside may be more limited than we previously thought. Relative flattening of the USD curve has gone hand in hand with less negative EURUSD CCS spreads 2Y-1Y US vs GER steepness EURUSD 5Y CCS aug-13 dec-14 maj-16 sep-17 feb-19 jun-2 Source: Danske Bank Overall, as the global hunt for yield seems very much alive, we fear that European rates may have a harder time steepening unless the USD curves steepen as well. Even if the timing is difficult, there are in our view signs that current USD pricing will be difficult to sustain over time. The expected US budget deficit remains strikingly large at this stage of the business cycle (around -4.2% of GDP for 219 according to the January 219 CBO projections). At the same time, foreign buyers seem to have deserted US treasuries in recent years (see chart below). Unless the curve steepens, we reason that domestics will have to absorb the increase in supply. This process might not go smoothly if the US outlook deteriorates sharply and (more) rate cut expectations start creeping into pricing. US budget deficit set to remain large near term Source: Macrobond Financial, CBO projections 3 1 March 219

4 Foreign holdings of US Treasuries stagnating Source: Macrobond Financial A steepening of the SEK swap curve remains our main scenario. However, we must acknowledge that we were somewhat disappointed that the debt office could not manage the recent shortfall in government income without increasing issuance. The SEK long end could still come under pressure from domestic factors if the Riksbank decides to stop QE purchases in June 219 (a decision is likely at the April meeting). However, as our rate of conviction has fallen, it may warrant a reduction in risk exposure in curve steepeners. Despite the significant yield curve flattening we have experienced since autumn 218 (in particular, the 2Y-5Y flattening was notable), the SEK curves still stand out as steep in an international comparison. While we have previously recommended the 3Y point as the sweet spot on the covered bond curves in terms of carry/roll-down for a repo-funded investor, that the hunt for yield remains a market theme speaks in favour of being more aggressive. This would mean looking at the longer covered bond maturities, where the potential in basis points is larger. Despite significant 2Y-5Y flattening, the SEK swap curve remains one of the steepest Source: Danske Bank Implied hikes in 5Y vs spot 3M SEK Swap 19 EUR Swap 91 USD Swap -5 NOK Swap 72 CHF Swap 85 AUD Swap 41 CAD Swap 23 NZD Swap 6 JPY Swap 5 GBP Swap March 219

5 Foreign holdings of SEK covered bonds close to historical record levels Source: Macrobond Financial An alternative to our 3Y-1Y swap steepener might be to look at buying 5Y covered bonds versus 1Y SGBs. Though broadly correlated with the swap curve, this position might be less exposed if the hunt for yield continues to dominate market movements. We would expect the demand for the higher yielding longer covered bonds to increase in a scenario where long rates continue to hover around lows. Since 214, 5Y covered bonds have rarely yielded more than 1Y SGBs (see chart below). Thus, we propose this trade (buying for instance SHYP1588, March 224, versus selling SGB161, Nov 229) as an alternative to a 3Y-1Y steepener. 5Y covered vs 1Y SGBs reasonably correlated with swaps 3Y/1Y and perhaps less exposed to hunt for yield aug-13 dec-14 maj-16 sep-17 feb-19 jun-2 Source: Danske Bank Consumers see higher mortgage rates Generic SEKSWAP 1Y vs 3Y Generic SEGOVT 1Y vs Stadshypotek 4.5Y An interesting observation in the February NIER business and consumer confidence survey is that consumers are more hawkish on rates than market participants. In our view, one reason for this might be that in December the Riksbank delivered the first rate hike in many years and banks raised variable (three-month) mortgage rates accordingly. In the meantime, Riksbank board members are urging borrowers to prepare for further rate increases. On the back of multiple years of ultra-low rates, there has been a strong preference for three-month rate mortgage loans, with such loans accounting for two-thirds of all mortgage loans March 219

6 The Riksbank has been successful in convincing people that rates are on their way up. The latest consumer confidence survey conducted in the period 1-15 February shows a distinct increase in consumers expectations of variable mortgage rates in one, two and five years. Consumers expect mortgage rates to raise Accumulated implied change in 1M forward OIS and 3M mortgage rates Accumulated implied change in 1m fwd OIS over: 1y 2y 5y 2,6 43,4 11,2 Accumulated change in 3M mortgage rates consumers: 1y 2y 5y Source: NIER Source: NIER, Danske Bank Mortgage lenders currently offer three-month rates in the proximity of 1.65%. With this as a starting point, current consumer expectations imply an accumulated increase in threemonth rates of some 15bp over the coming two years and 2bp over five years. This is more than is implied by money-market rates (see table above). Consumers rate expectations started to move up in October 218 and this coincides with a shift in borrowing behaviour. In effect, for the first time in many years, borrowers started to switch to fixed-rate loans. In the four months to end-january, the stock of fixed-rate loans increased by SEK113bn, while three-month rate loans have declined by SEK63bn. Consumers switching to fixed-rate loans Mortgage lending rate, sweet-spot around 2Y fixed 4 3 Fixed mortgages m/m bn Jul-9 Nov-1 Apr-12 Aug-13 Dec-14 May-16 Sep-17 Feb-19 Jun-2 Source: SCB Source: Macrobond Financial More granular data suggest that the bulk of switches from variable to fixed rates hits the one- to three-year segment and this appears to be quite reasonable considering the shape of the mortgage lending curve. This is worth monitoring considering that mortgage institutes typically issue covered bonds with a maturity of five years. Increased interest for fixed-rate loans in the one- to three-year segment from the borrowers side has the potential to trigger payer interest in swaps from the issuers sided, creating some upward pressure in swap rates up to three years. 6 1 March 219

7 Swedish GDP conceals falling domestic demand On the surface, Q4 GDP appears much stronger than expected, as it was +1.2% q/q and +2.4% y/y calendar adjusted. However, if you scrape off the paint from net exports and inventories, it left final domestic demand at just +.2% q/q and +.8% y/y, according to our calculations. The rest came from either inventory build-up (contribution.3pp q/q and.6pp y/y) or net exports (contribution.7pp q/q and 1.1pp y/y). Most of the latter came from net exports of services. Hence, although GDP looks fine, domestic final demand fell to the lowest level seen since Q1 13. Given the state of the domestic Swedish economy, with a deteriorating housing market and close to zero real wage growth, we are not really surprised. In a sense, the domestic part of the economy is in what could be called a technical recession. Looking forward, we expect net exports (where both goods and services net quite uncommonly has expanded for two consecutive quarters) to pull back. GDP is growing due to net exports and inventories GDP rises but domestic demand is falling Source. SCB Source: SCB In line with this story, our GDP indicator (does not include services exports or inventories) continues to suggest weakening GDP growth in Q1. GDP indicator suggests weakening growth in Q1 Source: SCB, Danske Bank 7 1 March 219

8 Next week, there will be some January data as input: the Production Value Indices (PVI) turned out surprisingly high in December. We expect some retracement in both the manufacturing sector and the services sector, as signalled by European manufacturing production and domestic services surveys. We estimate the household consumption indicator rebounded in January on the back of more vigilant retail sales, noting that last year s data has been revised lower. What does GDP tell us about the Riksbank? Q4 GDP figures were better than we expected at 2.4% y/y, versus our forecast of 1.9% y/y, and of better quality (less inventory contribution). It would be foolish to deny that the figure provides the Riksbank with a reason to stick to the strategy of delivering a second rate hike in the autumn (September). GDP was in line with the Riksbank s forecast. We fully recognise that the Riksbank has moved back from a focus on inflation to a more normal way of policymaking, taking a longer view on growth and inflation. Admittedly, we have been sceptical about a second hike in the autumn, partly because we believe the Riksbank (after all) is too optimistic on inflation and partly because we believe it is unlikely that Sweden could withstand a European growth slowdown. We opened a receiver position in SEK FRA Sep-19 on 1 January and the GDP numbers could be a reason to take the opportunity to close the position at almost zero cost. However, we take the risk of waiting. September is a long way off, eurozone data have been largely disappointing so far this year and one important piece of information is still lacking, namely what changes the ECB will make regarding the growth and inflation outlook and the possible policy implications of this. At the same time, if Q4 can be seen as supportive of a second rate hike, it should in our minds be equally supportive of ending QE for real by June. Until then, the Riksbank continues to reinvest the redemption of the Mar-19 SGB152. After this, it should be natural to stop reinvestments. Relief for the SEK In, 21 February, we elaborated on why the SEK has been this year s currency flop: (1) worse-than-expected macro data, (2) downward revisions of Swedish and global growth outlooks and, accordingly, more dovish central banks and (3 carry trades. In particular, we stressed the third factor, where the SEK become an attractive funding currency amid wide rate spreads and depressed volatility. Until Wednesday, the total return (including carry) on a long USD/SEK position was 4.9% YTD. The carry theme should still be relevant, although it is worth noting that carry positions have generally cost money, whereas the total return on long USD/SEK is -1.8%. Why? The answer relates to the first factor above. The GDP number was clearly better than expected, with private consumption and net exports stronger than we estimated and inventories not adding as much as we had thought. There were weak details too; in particular, residential investments fell and as in Q3 contributed negatively (-.4pp) to GDP growth. In our view, it is still likely that growth will slow in coming quarters, while housing will continue to weigh and it seems odd that the Swedish economy will steam ahead when the European economy slows down. That said, here and now it makes good sense to us to think that the Riksbank is content and will stick to growth rhetoric ( strong ). In our view, the immediate impact on EUR/SEK was fair with a decline from 1.55 to We stick to our 1.4 target for 1-3M. 8 1 March 219

9 As far as data is concerned, we note that the extended period of almost exclusively negative Swedish (and European) surprises has stopped. This is not unexpected given that the Surprise Index had reached rock bottom. Recently, production, NIER (ETI and manufacturing) and GDP have beaten expectations with a cumulated impact on EUR/SEK. After the PMI data today, focus is directed at the ECB next week and Swedish inflation data the following week, where our estimates are one-tenth (CPIF excluding energy) and three-tenths (CPIF) below those of the Riksbank. However, our impression is that the Riksbank stopped counting hundredths on the latest inflation print, though substantial deviations surely matter. Overall, taking into account fourth-quarter GDP, we believe it less likely that the Riksbank will make any changes to its rate guidance at the April meeting: we think it will stick to the message of a second hike after the summer. After GDP, the money market is pricing in 18bp (previously 16bp) through to year-end. If the market adapts to the view that the Riksbank will stick to its rate strategy, it should be somewhat of a relief for the SEK. KIX still above Riksbank forecast Source: Macrobond Financial, Danske Bank 9 1 March 219

10 Open strategies Source: Danske Bank 1 1 March 219

11 Calendar Monday, 4 March, 219 Period Danske Bank Konsensus Previous 1:3 EZ Sentix Investor Confidence Index Mar :3 UK PMI construction Index Feb : EZ PPI m/m y/y Jan -,8% 3,% 16: US Construction spending m/m Dec.2%.8% Tuesday, 5 March, 219 Period Danske Bank Konsensus Previous 1:3 JAP Markit PMI services Index Feb :3 SWE PMI services Index Feb :3 SWE Private sector producti on m/m y/y Jan,9% 4,6% 9:3 SWE Industrial orders m/m y/y Jan 3.1% 2.4% 1: EUR PMI composite Index Feb : EUR PMI services Index Feb : ITA GDP, final q/q y/y 4th quarter -.2%.1% 1:3 UK PMI services Index Feb : EZ Retail sales m/m y/y Jan -1.6%.8% 15:45 US Markit PMI service Index Feb : US ISM non-manufacturing Index Feb : US New home sales 1 (m/m) Dec (16.9%) 2: US Budget statement USD bn Jan Wednesday, 6 March, 219 Period Danske Bank Konsensus Previous 9:3 SWE Current account SEK bn 4th quarter :15 US ADP employment 1 Feb :3 US Trade balance USD bn Dec :3 US DOE U.S. crude oil inventories K Thursday, 7 March, 219 Period Danske Bank Konsensus Previous 6: SWE Maklarstatistik Swedish housing price data 6: JAP Leading economic index, preliminary Index Jan :3 SWE Average house prices SEK m Feb :3 SWE Budget balance SEK bn Feb : EZ GDP, final q/q y/y 4th quarter.2% 1.2%.2% 1.2% 11: EZ Employment, final q/q y/y 4th quarter.3% 1.2% 13:45 EZ ECB announces refi rate %.%.% 14:3 US Unit labour cost, final q/q 4th quarter 2.%.9% 14:3 EZ ECB's Draghi speaks in Frankfurt 21: US Consumer credit USD bn Jan Friday, 8 March, 219 Period Danske Bank Konsensus Previous :5 JAP GDP, final q/q ann. 4th quarter.3% 1.4% 8: GER Factory orders m/m y/y Jan -1,6% -7,% 8:45 FRA Industrial production m/m y/y Jan.8% -1.4% 9:3 SWE Household consumption m/m y/y Jan -.8% -1.% 1: ITA Industrial production m/m y/y Jan -,8% -5,5% 14:3 US Building permits 1 (m/m) Jan (.3%) 14:3 US Unemployment % Feb 3.8% 4.% 14:3 US Average hourly earnings m/m y/y Feb.3% 3.3%.1% 3.2% 14:3 US Non farm payrolls 1 Feb :3 US Housing starts 1 (m/m) Jan 178. (-11.2%) Source: Various sources, Danske Bank 11 1 March 219

12 Disclosures This research report has been prepared by Danske Bank A/S ( Danske Bank ). The authors of this research report are Michael Boström (Chief Analyst), Michael Grahn (Senior Analyst), Carl Milton (Analyst) and Stefan Mellin (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 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 March 219

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