Investment Research 16 July 2018 Reading the Markets Norway International political risk, in a slow domestic summer market, puts downward pressure on rates Macro: the domestic economy is still strong in contrast to the current pricing in the fixed income market. Fixed income: Domestic factors suggest upside potential for interest rates over the summer. FX NOK: New trades: Closed trades: NOK FX: sell summer straddle on rangy spot, lower volatility. Sell 2W EUR/NOK straddle. No closed strategies. Table 1. Danske Bank s market view in a nutshell 12th issue 2018 Reading the Markets Norway targets our institutional fixed income and FX clients. We produce it biweekly. Strategy performances will be updated in Reading the Markets Norway ahead but strategies may be opened and closed in between reports. Relative value Last update FX Position for next move higher in NOK 23.04.2018 Curve view (NGB) Steeper curve on wage inflation 23.04.2018 Swap spreads (ASW) Gradual ASW spread tightening 13.06.2018 Wider swap spreads vs international peers on wage Spread vs peers inflation 23.04.2018 Market gradually moving towards Norges Bank's Short-end [<2y] projections 02.07.2018 Norges Bank's policy rate 3m 6m 12m 0.75 % 1.00 % 1.25 % Chart 1. Forward 3M Nibor curve discounts limited interest rate hikes going forward despite Norges Bank s projection of a positive output gap at end-2018 1.00 3.00 0.50 0.00 Output gap, NB's projection 3m nibor (rhs) Fwd 3m nibor (rhs) 2.50 2.00 Chief Economist Frank Jullum +47 45 25 85 29 fju@danskebank.no -0.50-1.00 1.50 1.00 Senior Analyst Kristoffer Kjær Lomholt +45 45 25 85 29 klom@danskebank.dk -1.50-2.00 Mar 12 Sep 13 Mar 15 Sep 16 Mar 18 Sep 19 Mar 21 0.50 0.00 Head of Fixed Income Research Arne Anders Lohmann Rasmussen +45 45 12 85 32 arr@danskebank.dk Chief Strategist Jostein Tvedt +47 23 13 91 84 jtv@danskebank.com Important disclosures and certifications are contained from page 8 of this report. www.danskeresearch.com
International political turmoil the main risk to a September hike Chart 2. Moderate core inflation in line with Norges Bank s estimate Global turmoil, related mainly to international politics, appears to be the main risk to a sight deposit rate hike in September, as domestic data confirm a growth recovery. Only in the case of a major negative shock might Norges Bank refrain from hiking the sight deposit rate from 0.50% to 0.75% at the board meeting 20 September. It appears unlikely that Norges Bank will change the target rate at the first board meeting on 16 August. At the press conference on 21 June, Norges Bank governor Øystein Olsen expressed that the outlook and balance of risks suggests that the key policy rate will most likely be raised in September 2018. Domestic factors since then have not changed the main picture and an August hike should be out of the question. In our view, the August meeting may become interesting only as an opportunity for Norges Bank to adjust its guidance on a September hike and the steepness of the interest rate projection, in the case of increased international turmoil. Data since the June policy meeting have been in line with Norges Bank s projections. Core inflation for June at 1.1% y/y was spot on Norges Bank s projection and consensus. High electricity prices pushed headline inflation up to 2.6% (versus consensus of 2.4%). In addition to affecting electricity prices, unusually warm and dry weather in the south of Norway seems to have boosted household consumption. Retail sales in May were up a surprising 1.8% m/m (see Chart 4). The unusually good weather and positive real wage growth suggest fair growth in household consumption ahead. The housing market appears to be cooling somewhat following the strong recovery in the spring. According to Eiendom Norge, housing prices were unchanged in June, seasonally adjusted. An improved supply side and the traditional pattern of more moderate price growth in the second half of the year suggest a sideways housing market ahead. A somewhat softer housing market is according to Norges Bank s expectations and should not jeopardise the expected interest rate hikes short term In the 20 June Monetary Policy Report 2/18, Norges Bank projected the production gap will turn positive in the autumn (see Chart 1). We expect higher manufacturing production later this year, as the oil industry recovery is confirmed and new orders turn into real activity. During the oil market downturn, resources moved from the oil sector to the rest of the economy. This put significant downward pressure on wages, especially in 2016. This process is now about to be reversed and we estimate wage growth around 3% in 2018 and increased wage-driven inflation ahead. Despite the strong domestic growth outlook, market interest rates are significantly below Norges Bank s recent projections. It sees approximately two hikes per year over 2019-21, while the market discounts only one hike per year. From a domestic perspective, we share the optimistic view of Norges Bank: it is smooth sailing for the Norwegian economy ahead. However, given Norway s strong dependence on free trade, the oil market and efficient international financial markets (the petroleum fund), any escalation of the current international tensions could affect the Norwegian economy negatively to a significant degree and more strongly than it affects peers. From this perspective, the current depressed market rates may be fair. Being at the centre of the brewing storm, the current smooth sailing may be only temporary. However, if the current international turmoil subsides, the upside potential for Norwegian interest rates could be larger than for peers. Chart 3. Underlying inflation (corecore) moving upwards Chart 4. Retails sales strong start to the summer 106 104 102 100 98 96 94 92 90 Dec-07 Dec-09 Dec-11 Dec-13 Dec-15 Dec-17 Chart 5. Market rates are significantly below Norges Bank s MPR 2/18 projection from 2019 onwards 2.70 2.20 1.70 1.20 Retail sales, vol. s.a Historical 3m nibor Current market, 3m fwdnibor NB's 3m nibor MPR1/18 NB's 3m nibor MPR2/18 0.70 Dec 13 Jun 15 Dec 16 Jun 18 Dec 19 Jun 21 Source: Norges Bank, Danske Bank 2 16 July 2018 www.danskeresearch.com
We reiterate our existing strategies for higher Norwegian interest rates When international turmoil subsides, we expect higher absolute and relative Norwegian interest rates As discussed above, the current international turmoil appears to be heavily affecting the Norwegian fixed income market. While market interest rates in March were close to Norges Bank s Monetary Policy Report 1/18 projections, the market is at present significantly below Norges Bank s marginally upward revised projections from Monetary Policy Report 2/18 (see Chart 5). Our open strategies at present are for absolute higher Norwegian interest rates, a steeper interest rate curve or higher rates relative to Swedish peers. However, these strategies have not yet performed satisfactorily. We do not add any new strategies this time around. However, we still see upside potential in positioning for higher Norwegian interest rates. From a domestic business cycle perspective, we expect target rate normalisation in line with, or above, Norges Bank s projections. If data in the summer and early autumn confirm our expectations, the market forward interest rates should move towards Norges Bank s projection. As discussed above, the Norwegian economy is probably more vulnerable to any negative shifts in global free trade and financial market efficiency. Norway, a non-eu-member, with close ties to both parties in the negotiations, is also vulnerable to any adverse development in the Brexit negotiations. The Norwegian fixed income market may therefore be an interesting asset class for positioning for a normalisation of international trade and political conditions. We cannot attribute the current flatness of the Norwegian curves only to international fixed income risk-off. The usual summer slowdown restricts during the domestic generated flow. Last week, international long-end NOK issuances contributed to keeping the long-end flat. Generally, there has been some relative receiving interest in the market in recent weeks. Chart 9. Norges Bank set to hike twice a year from 2019 onward: sell NOK FRA 3M DEC18 and buy NOK FRA 3M DEC19 Chart 6. We expect spread widening in NOK FRA 3M MAR20 vs Sweden 160 155 150 145 140 135 Spread NOK FRA 3m MAR20 vs SEK MAR20 130 Jun-18 Jun-18 Jun-18 Jul-18 Jul-18 Chart 7. NOK IRS 2Y/1Y upside potential on market buying into NB 3.6 3.1 2.6 2.1 1.6 1.1 0.6 0.1 Aug 12 Aug 13 Aug 14 Aug 15 Aug 16 Aug 17 Spread NOK IRS 2y/1y - SEK IRS 2y/1y NOK IRS 2y/1y Chart 8. Unusually flat long-end NOK IRS curve 1.3 1.1 0.9 0.7 0.5 0.3 Spread NOK IRS 10Y - NOK IRS 6Y Spread NOK IRS 6y/4y - NOK IRS 2y/4y 30 29 28 Spread NOK FRA 3m DEC 19 vs DEC 18 0.1 Jul 12 Jul 13 Jul 14 Jul 15 Jul 16 Jul 17 Chart 10. NST476 ASW spread tightening over the summer 27 26 25 Jun-18 Jun-18 Jun-18 Jul-18 Jul-18 For our open strategies, see Table 2 and previous Reading the Markets Norway publications. As an outright operationalisation of our view on Norges Bank: In Reading the Markets Norway, 28 May, we suggested selling NOK FRA 3M DEC18 and buying NOK FRA 3M DEC19. The strategy should perform well if our production growth recovery case proves correct and the market starts to buy into Norges Bank s guidance of two hikes of 25bp in 2019. -32-34 -36-38 -40-42 -44-46 -48 NST 476 ASW Spread NO DE 5Y 15.02.2017 15.08.2017 15.02.2018 1.8 1.7 1.6 1.5 1.4 1.3 1.2 1.1 3 16 July 2018 www.danskeresearch.com
NOK sell summer straddle We still like to be positioned for the next leg lower in EUR/NOK via options (live PnL on our 3M seagull: +0.4%). However, the summer months tend to be characterised by lower volatility, poorer liquidity and a rangy spot. The domestic newsflow dries out and external development tend to have less of a spot impact than usual (e.g. last week s oil price decrease). We recommend selling a 2W straddle paying 820 pips (indicative prices). Summer characterised by poorer liquidity and lower volatility Since the June Norges Bank meeting, EUR/NOK has tested the 9.40 support level on several occasions (Chart 11). In our view, the primary reason it has failed has been the global environment, with weaker growth and trade war fears and improved structural NOK liquidity (Chart 13). Indeed, these were the reasons we preferred positioning for the next leg lower in EUR/NOK via options instead of via an outright spot trade. In addition, summer trading was a reason for putting on a volatility selling strategy in the options space. Normally, summer tends to be characterised by worse liquidity but also by lower volatility. Chart 15 shows how July and August tend to be the months with the lowest realised volatility. Chart 12 shows that historically the cross tends to range-trade in July, before shifting the range slightly lower in August as many return from holiday. A key factor behind the lower volatility is that domestic newsflow tends to dry up. This leaves the NOK market movers in the hands of external developments most noteably lingering trade wars but our expectation remains that the impact on the NOK should be very modest as the forthcoming rates support from a Norges Bank hike limits the upside risk for EUR/NOK. Specifically, Wednesday s 7% fall in the oil price barely affected the NOK, highlighting the summer resilience. In addition, the weekly flow data from Norges Bank show that, after several consecutive weeks of heavy NOK buying, foreign banks (proxy for speculative flow) suddenly sold NOK significantly in the previous week. It is likely this reflects taking ahead of the summer. If we are right, it would also suggest potential for additional longs to be added once we reach August but not before then. In other words, the fundamental case for a lower EUR/NOK remains in place but in the near term the cross is likely to remain rangy. Chart 15: EUR/NOK realised 1M volatility, by month and period (%) By Months Since 2007 2007-2009 2010-2012 2013-2015 2016-present Dec 10.93 14.53 6.25 13.82 8.24 Nov 9.27 12.51 6.63 9.24 8.43 Oct 9.46 13.95 7.61 8.72 6.64 Sep 8.92 9.55 9.32 9.36 7.02 Aug 8.48 8.34 8.95 9.45 6.48 Jul 8.00 7.94 7.73 8.87 7.14 Jun 8.87 9.34 7.92 10.16 8.21 May 8.59 10.03 9.49 7.83 7.49 Apr 7.25 9.62 6.20 7.18 6.79 Mar 8.94 12.44 7.38 8.91 8.19 Feb 8.28 10.95 7.05 8.37 7.63 Jan 9.16 13.34 6.75 10.04 7.91 Source: Bloomberg, Danske Bank EUR/NOK strategy: keep 3M ratioed seagull, sell 2W straddle EUR/NOK forecast: 9.40 (1M), 9.20 (3M), 9.20 (6M) and 9.10 (12M). Leveraged funds. We still like our previous recommendation to position for the next move lower in EUR/NOK via a 3M ratioed seagull (see FX Strategy: Sell 3M EUR/NOK seagull on lower spot and volatility, 11 June). In addition, we recommend playing a rangy spot and lower near-term volatility by selling a 2W EUR/NOK ATMF straddle, paying 820 pips (spot ref 9.4852, indicative prices). Chart 11. EUR/NOK eventually set to break lower testing 9.22 Chart 12. but seasonality suggests near-term rangy spot Chart 13. Structural liquidity Chart 14. Speculative accounts taking ahead of summer? Chart 16. 2W EUR/NOK straddle 4 16 July 2018 www.danskeresearch.com
Bond investors should seek to lower hedge ratios on NOK exposure (3M horizon). Real-money funds. We recommend rolling EUR hedges short (3M) while extending USD hedges further out on the curve (1Y). Table 2. Open strategies and trades with recent status change Type Trade Idea Target & P/L Status FX Sell 2W straddle Play rangy spot and lower volatility by Opened 16-Jul-2018 New selling short-dated straddle Start 9.4852 Note: Indications generally based on mid-market prices some hours ahead of the publishing of the report Target/stop P/L Money Market Buy NOK FRA 3M MAR20 and sell Steeper NOK FRA curve for 2019-20 Opened 26-Jun-2018 SEK FRA 3M MAR20 on stronger relative Norwegian Start 146 economy vs Sweden Target/stop 170/135 Now NA Now 146 P/L 0 Fixed Income Reduced asset swap spread NST Tighter mid segment ASW spread on Opened 13-Jun-2018 476 less concave IRS and reduced Start -42.5 international political risk Target/stop -27/-48 Now -46.5 P/L -4 FX Enter 3M bearish EUR/NOK ratioed Position for next leg lower in Opened 11-Jun-2018 seagull EUR/NOK as Norges Bank hiking Start 9.515 cycle constitutes important fundamental trigger. Target/stop NA Now 9.4852 P/L 0.40 % Money Market Sell NOK FRA 3M DEC18 and buy Market interest rates for 2019 to Opened 28-May-2018 NOK FRA 3M DEC 19 move towards Norges Bank's Start 31 projection Target/stop -45/-24 Now 28.5 P/L -2.5 FX Sell NOK/SEK spot outright Sell NOK/SEK on tactical basis as a Opened 13-Jun-2018 way of positioning for modest NOK Start 1.0755 setback and continued near-term SEK support. Target/stop 1.060/1.086 Now 1.0739 P/L 0.13 % Money Market Pay NOK IRS 4Y and SEK IRS 2Y Relative inflation and growth outlook Opened 15-Mar-2018 and receive NOK IRS 2Y and SEK and lower Nibor going fwd Start -18 IRS 4Y Target/stop 0/-30 Now -13 P/L 5 Money Market Pay NOK IRS 2Y/8y and SEK IRS Opened 23-Apr-2018 2Y/3Y and receive NOK IRS 2Y/3Y Start -34 and SEK IRS 2Y/8Y Target/stop -15/-45 Now -38 P/L -4 FX Sell EUR/NOK spot outright. Downside potential on relative Opened 5-Mar-2018 growth, valuation, positioning, relative Start 9.6541 rates and global outlook Target/stop 9.25/9.84 Now 9.495 P/L 1.69 % 16 Mar 5 16 July 2018 www.danskeresearch.com
Table 3. Most recently closed strategies Money Market Sell NOK FRA 3m JUN18 and Increased probability of September Opened 12-Mar-2018 DEC18 and buy NOK FRA 3m hike relative to December and Start 7.5 SEP18 normalisation of cash liquidity Target/stop -10/15 Note: Indications generally based on mid-market prices some hours ahead of the publishing of the report Now -1.5 P/L 9 Money Market Pay NOK IRS 2Y/1Y outright (as Higher short-end interest rates on Opened 19-Feb-2018 alternative to existing relative increased risk of wage inflation Start 191.5 strategies) Target/stop 225/175 Now 189 P/L -2.5 Money Market Pay NOK IRS 6Y/4Y and receive Excessively flatness will be reverted Opened 5-Feb-2018 NOK IRS 2Y/4Y as mid segment normalises vs the Start 48 long-end Target/stop 70/35 Now 42 P/L -6 Fixed Income Reduced asset swap spread NST Wider short-end ASW spread on Opened 5-Feb-2018 473 potential for a NOK rally Start -54 Target/stop -65/-45 Now -60 P/L 6 Money Market Pay NOK IRS 2Y/2Y and receive Norwegian and euro-area economic Opened 22-Jan-2018 USD IRS 2Y/2Y recovery may suggest that the spread Start -87 will tighten long-term Target/stop -40/-110 Now -110 P/L -23 Money Market NOK IRS 2Y-5Y+10Y 'Butterfly' Stronger NOK may reduce medium Opened 8-Jan-2018 term inflation expectations Start 0 Target/stop 20/-10 Now -10 P/L -10 Money Market Sell SEK FRA 3m MAR 2019 and Receive SEKFRAMAR19 and pay Opened 15-Dec-2017 Buy NOK FRA 3m MAR 2019 NOKFRAMAR19 in a spread on Start 113 relative monetary policy Target/stop 127/100 Now 127 P/L 14 FX Sell 3M EUR/NOK 1:1:2 ratioed Position for stronger NOK FX and Opened 5-Dec-2017 9.4500-9.8261-10.1000 seagull utilise rise in implied volatility to Start 9.8261 obtain protection against year-end Target/stop "N/A" liquidity Now 9.5718 P/L 1.80 % FX Buy NOK/SEK spot outright Position for stronger NOK, housing Opened 5-Dec-2017 market differences between Norway Start 1.0144 and Sweden and year-end liquidity Target/stop 1.100/0.985 Now P/L 7.60 % Fixed income Reduced asset swap spread NST Increased demand in the mid Opened 13-Nov-2017 474 segment for Norwegian government bonds on potential new-year NOK rally Start -38 Target/stop -55/-30 Now -47 P/L 9 12 Jun (target hit) Stop loss 14 May Stop loss 29 Jan Target met 20 Feb 16 April 6 16 July 2018 www.danskeresearch.com
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), Kristoffer Kjær Lomholt (Senior Analyst), Arne Anders Lohmann Rasmussen (Head of Fixed Income Research) and Jostein Tvedt (Chief Strategist). 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 ability 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 Biweekly. 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 division of Danske Bank A/S). It is provided for informational purposes only. 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 s, 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. 7 16 July 2018 www.danskeresearch.com
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: 13 July 2018, 13:44 CEST Report first disseminated: 16 July 2018, 06:45 CEST 8 16 July 2018 www.danskeresearch.com