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Sweden: Riksbank comment

Thu, Oct 22 2009, 18:45 GMT
by Marcus Söderberg

Danske Bank A/S

The Riksbank's announcement was much in line with what we expected. However, the new fixed-rate long-term repo was not completely anticipated. Our current trading recommendations have, in general, benefited from the meeting.

Back-loaded policy

With exactly the same repo rate path as in September (but extended by one quarter) the Riksbank once again attempted to persuade markets that they are premature in pricing in rate hikes. Cases suggesting early hikes are typically based on macro data showing reasonably clear signs of recovery. But we believe it is important to recognise the fact that the starting point for the recovery is far from normal. Hence we have argued that at this stage the Riksbank will probably not be very sensitive to stronger macro data. As we see it, this is illustrated in
today’s policy report. Observe that the Riksbank has made several upward revisions of macro assumptions: Global and Swedish growth somewhat higher, employment less negative and unemployment a little lower than in the September-forecast. The rate path is, however, exactly the same. So, as we have described in previous reports, the simple story is:

1. Inflation and inflation expectations are not perceived to be a policy restriction in the forecast horizon.
   
   
2.  Resource utilisation is low, so given the assumption in point 1, the reasonable policy aim is to conduct a policy that contributes to a more normal resource utilisation being reached within a reasonable period of time. That is to say, maintain low rates for a considerable period of time.

On the other hand, we believe that unless the overall macro picture deteriorates in an unforeseen way, the Riksbank will have reasons to normalise rates at a pretty smart pace when the time comes – maybe even along a steeper path than is currently perceived. A couple of factors need attention here. The first relates to resource utilisation. There is little doubt that any reasonable estimate would be at a low level. But probably not as low as suggested by traditional measures – basically standard measures of the GDP-gap. Even in normal times, this is a variable that is difficult to get a good grip of. In the current environment it is even more difficult. We believe that the Riksbank is gradually shifting focus toward the labour market, or more specifically employment, as the preferred measure of resource utilisation. Now, the Riksbank points to the fact that in relation to: a) The sharp decline in GDP; and b) The dramatic fall in employment in the early-1990s crisis, that the current deterioration has been rather moderate.

In fact, the widening of the output gap according to standard measures is quite comparable to the early 1990s, but the decline in unemployment isn’t even near the collapse then.
The reason could be a decline in potential productivity and the conclusion would be that resource utilisation in a true sense isn’t just as low as indicated by the GDP-gap. We too have observed this fact. Another way to explain this, as we see it, could be that the overall decline in GDP is distinctly unevenly distributed between sectors. Basically, manufacturing has taken a big blow with a fall in value-added of almost 25%. Other sector (trade services, etc) are not even close. It could very well be that several years of sharp productivity gains has made manufacturing firms so slimmed down that they are facing what micro-economists call “indivisibility”. In any case this is an important factor to monitor going forward and should employment continue to perform better next spring it could become a factor for the pace of rate-normalisation.

Finally house prices. The issue is addressed in the report, although not in an alarming way. The Riksbank makes a fair point in saying that monetary policy isn’t the only (and perhaps not the best) tool for guiding asset prices. Nonetheless, new gains in prices are observed and the price level is described as somewhat stretched. The Riksbank says that the assumption is that further price gains will be slower. We are not altogether convinced, at least not as long as rates are extremely attractive for borrowers. This is one reason why we believe that house prices (and lending) will get further into focus and something that could result in a somewhat steeper pace of rate increases further out. From this point of view the market response in terms of a steeper FRA-curve appears fully justified.

Current trading recommendations after Riksbank 

The Riksbank comments from the repo rate announcement in the Monetary Policy Report were, in general, very much in line with the reasoning that we have had ahead of the report. Hence our recommendations have almost all fared well after the Riksbank. Admittedly, we did not expect a new long-term fixed-rate repo facility but the announcement of a new 11-month repo rate has, in general, had a good impact on our recommendations. Recently we have been uncertain about the outright direction in bond yields and money market rates and thus our current trading recommendations have been much involved in various relative value strategies. We have been in favour of the 1.5Y bond; SGB1045, on the back of good carry and on our projections about the Riksbank. We have recommended buying SGB1045 in an ASW spread. The strategy is in-the-money and we believe it can continue to perform by a few basis points. At the short end of the curve we have also recommended to be long in the FRAJUN10 contract (sell). This strategy was initiated a month ago and has so far generated a profit equal to 16bp. However, we expect that the rate could decline more. We have also recommended selling the JUN10 against the JUN12 contract for a steeper FRA curve. The curve has steepened as expected after the Riksbank meeting, but we see more potential and maintain this recommendation. The spread trades at 250bp but both we and the Riksbank expect hikes to amount to 350-375bp during this timeframe.
The FRA/Swap curve is flat relative to bond curves (Govies and mortgage bonds) beyond the June 2011 point. On the back of this we have recommended an extension between 1.5Y and 3Y on the mortgage bond curve and between 3Y and 4.5Y on the Government bond curve relative to the FRA/Swap curve. The strategies have started to perform but we expect things to move much more in our direction. We reiterate our recommendations.
Additionally, we have recommended, as a long-term position, buying the linker SGBi3106 in a BEI spread against SGB1046. In our view, the zero implied BEI rate is currently much too low compared with our inflation rate forecast, 1.5% in the market compared with our forecast of 2.1% up to the maturity of the SGBi3106. The real rate bond SGBi3106 trade at 0.175%. But given the projections (our own and the Riksbank’s) on the repo rate and the inflation rate up to the maturity of the bond the average real repo rate will be roughly -1.45%! On average the real repo rate in 2010 is -0.6% and -2.3% in 2011. In this context the current real yield at 0.175% is much too high.
The long end of the bond curve looks dear relative to European peers and to swap rates. We have recommended selling SGB1052 against bunds and, to some extent, based on the same reasoning we have recommended buying SGB1049 ASW and selling SGB1052 ASW together with SGB1046ASW in an ASW barbell. The cross-country spread has struggled but we see the spread tightening despite the soft Riksbank as a good sign. The ASW barbell as performed on the back of the Riksbank. We recommend maintaining the strategy.
5Y mortgage bonds have performed extremely well relative to Government bonds and ahead of the index duration shortening next month we have been in favour of a relative flattening of the mortgage bond curve. The position has moved a couple of basis points but we expect more. Moreover have argued to sell 5Y mortgage bonds relative to Government bonds. The performance has been sluggish but for the moment we maintain our recommendation. However, the spread has tightened on the back of the new fixed-rate repo facility.

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Published on  Thu, Oct 22 2009, 18:50 GMT