Investment Research

12 January 2017

Outlook 2017 Fixed income strategy Sweden 2017 – heaven or hell?

Key themes 2017  The Riksbank can afford to be a bit more relaxed. QE extension beyond H1 17 in

question.  Near-term inflation deviations from Riksbank forecast insignificant – medium-

term view intact.  However, in order to avoid a too strong krona, the first hike is set to be postponed

again.  Keep an eye on the Swedish krona and how it moves with the money-market

curve.  Is this the end of Riksbank QE?  Expectations of a ‘kick start’ by Trump are high. Will it really materialise? Analysts

See next page for Key Trades 2017. Strategy/Macro Michael Boström +46 8 568 805 87 [email protected] Michael Grahn +46 8 568 805 88 [email protected] Strategy/Fixed Income Marcus Söderberg +46 8 568 805 64 [email protected] Carl Milton +46 8 568 805 98 [email protected]

Important disclosures and certifications are contained from page 45 of this report.

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Outlook 2017

Key themes 2017 Directional  Receive front FRA contracts, blue or red.  Receive SEK 2y1y or SEK 1y1y.  Sell EURSEK, possibly as a hedge for the trade above.

Relative value  Sell SGB1054 and buy SGB1059 in a curve flattener.  Pay SEK 5y and receive SEK 10y in relative flattener vs EUR.  Buy 3y covered bond vs swaps, SHYP1583 ASW.  Buy SGB1059 ASW.

Bond portfolio management  Neutral in covered bonds, underweight SGBs and add 2-3y Kommuninvest.  Underweight 5y covered bonds and overweight 3y covered bonds. Overweight 10y SGBs (SGB1059).

FX  Sell EURSEK

Trades to monitor for later in the year  Buy SGB1052 or SGB1047 ASW.  Curve steepener, 2s10s, in SGBs or SGBis when we near the end of QE.  Sell 10y real rate outright.

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Outlook 2017

Contents Riksbank after QE ........................................................................................................ 4 Baseline assumptions for the rate outlook ..................................................................................................... 4 Did QE and negative rates have an effect? ...................................................................................................... 7 Inflation outlook – a volatile turn of the year.................................................................................................... 9 Underlying inflation remains subdued ............................................................................................................ 10 Model simulation backs our story ..................................................................................................................... 12 Conclusion – what to expect from inflation and from the Riksbank in 2017........................ 13

Swedish fixed income Q1 17 – the big picture....................................... 14 Elevated forward implied TED spreads offer value in blue and red FRA contracts ......... 18 Trades ................................................................................................................................................................................... 22 Flattening of the 5s10s Swedish yield curve ............................................................................................. 22 Trades ................................................................................................................................................................................... 25 Will households eventually move to fixed rate mortgages? ............................................................ 25 Supply: first a new 10y bond – later the end of QE ................................................................................. 28 Life after Riksbank QE ................................................................................................................................................ 30 Covered bonds – index extensions should give some support ....................................................... 32 Kommuninvest interesting alternative to covered bonds ................................................................. 40 Index-linked bonds – BEI levels out of whack with expected rate hikes .................................... 41

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Outlook 2017

Riksbank after QE Baseline assumptions for the rate outlook 

Macro data: Compared with expectations, macro-data underperformed distinctly during the second half of 2016. Recent data have performed much better, especially survey based ones. The surprise-index has shifted from a deep low in October to levels close to earlier highs. This swing also reflects that expectations have adapted to the fact that Sweden’s growth momentum – after the 2015 boom – has geared down towards a more normal pace (2-2.5% growth). For the coming couple of quarters, we think that macro data will have be rather neutral from a market perception point of view. Near term (Q1), we see a case that expectations might get a bit ahead of themselves again though (surprise index looks toppish again). Positive data-surprises and higher energyprices (inflation expectations) coincide with a steeper FRA curve.



Inflation: Our medium-term view on inflation is intact. Domestic cost pressures (via wages) remain modest, in fact too modest to generate a self-sustained 2 percent inflation rate. Fierce competition in retailing remains in place. For the coming three-six months, however, with another round of indirect tax increases, higher energy prices and possibly lagged SEK effects, CPIF inflation is likely to come in relatively close to the RB’s current projection. This should keep expectations of future rate hikes alive.



Riksbank QE: The RB’s government bond purchases continue through H1, but will likely not be extended thereafter. Ending QE is partially done to avoid absorbing too large a share of the stock of nominal government bonds.



The krona: Last year was a year of SEK weakness. We see a good case for that trend to reverse. The RB is probably more patient now than for instance in late 2015 regarding SEK strength. But in case KIX approaches around 110 ahead of the April RB meeting, we think the response will be to delay rate hikes further into 2018, especially if the market by then is pricing in faster rate hikes than expressed by the RB path.



Supply: Last year, there was a strong case for the Debt Office reducing the supply of (nominal) SEK bonds. This was a reason why we argued for spread tightening versus Germany. The Debt Office (DO) finally scaled back supply (for 2017) from SEK77bn to SEK66bn. This time around we do not see a strong case for lower supply.

Chart 1. Surprise index from too low to too high

Source: Bloomberg, Macrobond Financial

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Outlook 2017

The Riksbank’s December policy decision to continue government bond purchases (SEK15bn each in nominal and index linked bonds) attracted limited attention. Instead markets took notice of the fact that three out of six board members dissented; two members didn’t see reasons for an extension at all and one board member saw it as sufficient to purchase another SEK15bn in inflation-linked (IL) bonds. We have for some time suspected that in case the RB were to prolong its QE programme, it would probably be the ‘final shot’, if not else so for technical reasons. We had a similar situation in April, when deputy governor Cecilia Skingsley voted against extending QE through the second half of 2016. Her argument then was that since inflation and inflation expectations had recovered, there were at the time no convincing reasons for adding more stimulus. There is an important issue embedded here: whether a specific policy decision means that stimulus is added, maintained or reduced. Skingsley’s arguments then were that an extension of QE per definition implies added stimulus. We are less certain; we would argue that the effect of a specific decision relies on its impact on market interest rates and the krona. So what is our base case regarding RB policy going forward? We stick to the baseline scenario that government bond purchases (apart from re-investments of coupons and redemptions – see more in separate section) will be ended by the end of Q2. The repo rate is likely to be held unchanged through 2017 at -0.5% and depending on the extent and pace of SEK appreciation, likely beyond that point. Does this also mean that we have altered our view on the extent to which the RB can deviate (in terms of rates) from the ECB – the answer is no. The ECB has recently decided to continue QE at least through 2017 and to keep rates low/lower well beyond the point in time when QE stops. That might be well into 2019 we reckon, considering that the ECB is unlikely to abruptly stop asset purchases by the end of this year. The focal point here is of course the krona. In December 2015 (30 December to be precise) RB governor Ingves made the unusual decision to make a statement on the exchange rate (link to press release here), warning that the Riksbank was prepared to intervene if the krona continued to appreciate. Chart 2. The krona sets the limit

Source: Macrobond Financial

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Outlook 2017

The krona had appreciated gradually since summer 2015. In November, the SEK-index (KIX) rapidly dropped further (stronger krona), which then coincided with a sharp steepening of the money market curve (in this case illustrated by the spread between the eight and the second FRA contracts). The Riksbank’s December 2015 KIX-forecast was 111.6 for Q4 15 and 110.3 for Q1 16. By the date of Ingves’ statement the index was 108.22, in other words 2% stronger than projected. After the statement, the money-market curve reversed significantly and the krona stabilised. However, during spring, the krona moved stronger again but the money market curve didn’t steepen as much as before year end. This time around, there was no specific statement about the exchange rate; instead the RB decided to announce an extension of QE. We think that the reason why the RB got so concerned in December was twofold. First the speed with which the krona strengthened and second that it coincided with expectations of much more aggressive rate hikes – suggesting that the appreciation was driven by expectations of a more hawkish Riksbank (rather than external factors). Observe that Ingves did not specifically mention rates in the December statement. Nevertheless, the result was all the same a distinct repricing (flattening) of the money market. This is of course perfectly logical. If the Riksbank officially states concern about a too rapid SEK-appreciation, expectations of rate hikes should be scaled down. Could the krona make the Riksbank worried again? Obviously yes. We think that the krona remains an important variable, especially until there is convincing proof of domestic costs and inflation taking off. The krona has weakened (and has been weaker than according to RB forecasts) through much of 2016. But more recently that trend appears to have reversed and again the drop in KIX moves in tandem with a steeper FRA-curve. Compared with the RB December 2016 forecast, the current KIX-level is about 2% stronger than the forecast for Q1 17 and at about the level projected for the third quarter this year. Compared with the situation in December 2015 when Ingves warned about FXinterventions, there are several reasons why the RB is likely to be more patient this time around. A) Relevant inflation expectation measures are closer to target. B) CPIF-inflation is about half a percentage point higher. C) The krona is still considerably weaker than in late 2015 and D) oil prices (and several other commodities) recovering contrary to what was the case in late 2015. Chart 3. SEK can't appreciate too rapidly

Source: Riksbank, Macrobond Financial

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Outlook 2017

Still, while 2016 was a year of SEK weakness, we think this year will be different and see a good case for a stronger krona. Near term inflation should be held up by another round of tax increases, higher petrol prices and possibly lagged effects of last year’s higher USDSEK. This, in turn, is likely to keep expectations of rate hikes alive simply because the next several months’ actual inflation levels aren’t likely to deviate much from the RBforecast. We think this will be an important driver for a stronger krona. The Riksbank’s patience of course also very much depends on the speed of the appreciation relative to forecast. The RB’s current forecast for KIX in Q3 17 is 114, not far from where it is trading now. A guesstimate from our side is that if the krona ahead of the 26 April policy meeting were to approach 110 (the projected entry-level for 2019), the RB would try to cap (or curb) market expectations of rate hikes by postponing the first hikes further into 2018.

Chart 4. Riksbank KIX forecast

RB KIX-fcts Q1 Q2 Q3 Q4

116.00 114.97 114.00 113.15

Source: The Riksbank

Did QE and negative rates have an effect? The Riksbank started its unorthodox monetary policy by pushing the repo rate into negative territory and by doing the first round of government bond purchases in February 2015. After almost two years it holds SEK237.5bn in nominal bonds, almost 38% of the stock; in some issues RB holdings clearly exceeds 40%. More details about the QE-programme are described in a later section. This means that the central bank is already now is the single largest owner of Swedish government bonds, exceeding the combined holdings of foreign investors and Swedish lifeinsurance companies, respectively. In addition, the Riksbank has purchased government bonds at a very rapid pace compared with peers and currently holds a larger share of the stock than Bank of Japan. Chart 5. Riksbank is number one owner

Chart 6. Share of bond markets held by central banks – Riksbank, BoJ and ECB (ECB holdings of Bund stock assuming 0% of purchases in agencies (grey) and no purchases in agencies (light blue) 40%

BoJ

35%

Riksbank

30%

Est. ECB holdings (20% of purchases in agencies) Est. ECB (no purchases in agencies)

25% 20% 15% 10% 5% 0% Jul-09 Source: Macrobond Financial, Danske Bank Markets

Nov-10

Apr-12

Aug-13 Dec-14 May-16 Sep-17

Source: Macrobond Financial, Danske Bank Markets

To put it differently, the RB asset purchase programme has to date reduced the free-float of bonds by 40% and rising. Has this policy been successful and in what way? It is of course very hard to distinguish what is the result of RB policy and what is the result of other factors.

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Outlook 2017

Chart 7. Government bond yields

Chart 8. Weaker SEK 2016

Source: Macrobond Financial

Source: Danske Bank Markets

Chart 9. ASW-curve now compared before the QE programme started -30 -35 -40 -45 2017-01-11 -50 -55 Jan-15

2014-12-01 Jun-20

Dec-25

Jun-31

Nov-36

May-42

Source: Danske Bank Markets

Simply looking at yield levels today and comparing with the situation just before the start of QE, the Riksbank has – at face value – been successful considering that the entire curve, except for the two longest loans – is consistently lower than when QE started. But this is of course a naïve ‘analysis’ considering that Swedish yields have fallen along with lower global yields over the past two years. Another way to address the issue is to investigate changes in the asset-swap curve over the period. Obviously, the most significant change is the spread widening that has occurred in the 2023-2026 (SGB1057-SGB1059) segments. This might seem strange considering that purchases of these three loans represent a relatively small share (some 35%) of total purchases by the Riksbank. An explanation might be that the yield of shorter maturities has been pushed deeper into negative territory for other reasons, making them less attractive for investors, explaining why the crowdingout effect has been greatest for 7-10 year bonds. One might ask if lower rates really have had any meaningful real-economic effect. Possibly – we think – on consumer spending but we doubt that this is to be seen as a ‘positive effect’ for the right reason. There is little doubt that ultra-low-rates have underpinned asset prices and boosted the housing market. This, in turn, has probably helped to support parts of the consumer goods sector. One can certainly doubt if that effect is worth the risks though. But we do believe that central bank induced low- or even negative rates have been one important reason for the (until recently) weakening of the krona. Where the krona is heading seems to correlate relatively well with inflation expectations. To the extent the Riksbank initiated negative rates and QE in early 2015 to stop inflation expectations from falling further, one might say that policy has served its (the Riksbank’s) purpose.

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Outlook 2017

Chart 10. Weaker krona helped to lift inflation expectations

Source: Prospera, Macrobond Financial

Inflation outlook – a volatile turn of the year Swedish inflation appears likely to have ended 2016 with a bang. Not only is December inflation likely to have outpaced the Riksbank’s forecast, CPIF is also likely to print close to 2% for the first time since December 2010. That said, it is very important to determine the features of the inflation drivers not to get lost in the upward momentum. In our view, a significant part of the increase is due to temporary factors. Chart 11. Air fares create volatility

Chart 12. Dec CPIF above Riksbank

Source: Travelmarket, Statjstics Sweden

Source: Riksbank, Danske Bank Markets

This time, December inflation will be hit by some exceptional events pushing inflation higher momentarily. Firstly, OPEC’s decision to reduce supply has caused a ‘lift’ to petrol prices. Secondly, international airfares and prices on charter packages appear to have soared, according to Travel market figures. We are not sure why as the Christmas/New Year 2016 period was mostly on week-ends. This usually means less demand for travel. The data also suggest a corresponding plunge back in January. Hence, air fares are only creating inflation volatility but add nothing in terms of lifting average inflation over time. Furthermore, January will again – like last year – be hit by a number of tax increases or higher public charges. For instance, alcohol and petrol taxes and likewise charges for the electricity grid, public transportation and TV licences are set to be raised. In all, these are likely to add 0.3-0.4 percentage points to inflation. Despite that public price shock, inflation is likely to slow down in January again. And more longer term, we expect inflation to moderate and stabilise well below the inflation target.

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Outlook 2017

Underlying inflation remains subdued There is nothing that suggests that the underlying inflationary pressure is rising. The analysis is quite straightforward and rests on the same pillars as it has for the past years. Wage cost is the prime determinant of domestic inflation. We basically see no change to the outlook. The run-up to spring wage negotiations shows the usual differences between employee and employer organisations. The outcome of central negotiations is likely to end up at just above 2% as in the past years. That is a level that is incompatible with attaining the inflation target, as roughly 40-50% of nominal wage increases are pushed on to the consumer. Chart 13. Weak wage growth has restrained domestic inflation

Source: Statistics Sweden, Mediation Office

Imported inflation stands for about 30% of the CPI basket. That suggests the currency is likely to have an impact on import prices. This is only partly correct. Over time, as the SEK has been roughly unchanged since the introduction of the inflation target, the krona has had no impact on (average) inflation. However, when the krona trends from one extreme to another (from strong to weak or vice versa), it has a significant impact on import prices and hence on inflation. The krona weakened in H2 16 to a level we deem as undervalued. The lagged effect of that depreciation is incorporated in our 2017 inflation outlook and in that sense the forecast is consistent with the current SEK weakness. Short term, however, we need to monitor that the impact of the depreciation on import prices is what we have assumed. Chart 14. SEK had no inflation impact on average over time – but is important when it trends

Source: Riksbank, Statistics Sweden

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Outlook 2017

Recently, the SEK has turned stronger. If it continues on that track, we probably need to reassess our forecast for inflation in H2, as this would have a depressing effect on inflation. Beneath the FX movement there is a more fundamental factor to consider: global goods prices. And goods prices are for obvious reasons strongly correlated to import prices. To a large extent, goods are produced in China, suggesting a need to gauge what is happening to Chinese export prices for consumer goods. Chart 15. Strong correlation between CNYSEK and Swedish consumer import prices

Source: Bloomberg, Statistics Sweden

For instance, there is a surprisingly strong correlation between Swedish consumer goods import prices in PPI (i.e. before hitting the consumer) and CNYSEK. Currently, Chinese export prices are still in decline but the pace is decelerating. This means that there is still a global deflation in goods prices that needs to be taken into account when forecasting import prices. Chart 16. On a global level China still appears to be exporting deflation

Source: Macrobond Financial

From time to time commodity and electricity prices can have a big impact on inflation. As with the currency, however, prices need to trend to have such an impact. Currently, there is no strong case for a trend in neither oil nor electricity prices. Normal seasonal price swings are assumed in our forecasts. All in all, we expect inflation to remain subdued over the coming two years, trailing behind the Riksbank’s forecast for most of the time. And this is independent of which measure is preferred: CPI, CPIF or CPIF excluding energy.

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Outlook 2017

Chart 17. Quite similar CPI forecasts 2017

Chart 18. But core inflation below 1% 2017

Source: Riksbank, Danske Bank Markets

Source: Riksbank, Danske Bank Markets

Model simulation backs our story Forecasts can always be criticised for encompassing a big amount of subjective opinions. Hence, to check our inflation outlook we use a model to lay out inflation scenarios, which are based on market pricing and survey expectations. The chart below shows scenarios for CPI, CPIF and CPIF excluding Energy and all are based on the same set of exogenous variables, although not all of them are used for each inflation forecast. The idea is NOT to give a shortterm forecast but rather to get an indication of what current market pricing and expectations imply for these three measures of inflation in the medium term. As can be seen in the chart below, the core measures are expected to stabilise just above 1%, while headline CPI should stabilise at 1.5%. This actually illustrates an inconsistency visible also in the bond market, i.e. that BEI inflation is priced well below 2% while forward rates at the same time imply several Riksbank rate hikes. One can of course question why the Riksbank should hikes rates if inflation does not overshoot 2%, but that is nonetheless what these data imply. Chart 19. Expectations/market futures imply inflation below 2% for long

Source: Bloomberg, Macrobond, Nordpool Spot, CBoT, Danske Bank Markets

These forecasts are based on the following. (1) Expected wage growth in terms of Prospera wage expectations. The average of Social Partners’ wage expectations on one, two and five-year horizons are used. This is the most important variable explaining the level of inflation. Current expectations are simply too low to generate sufficient wage cost to raise domestic inflation to the ‘appropriate’ level. (2) The ‘expected’ path for the KIX currency index. The KIX path is in itself forecast on the spread between a KIX-weighted average of 1y forward rates on USD, EUR, GBP and NOK against forwards in SEK. (3) Oil prices are gauged from Brent futures. (4) Electricity prices are gauged from Nordpool futures. (5) The impact of Riksbank rate hikes on mortgage costs is gauged using 1y forwards (swaps) as a proxy. As seen below, the simple mechanics of the expected paths of these variables suggest that the resulting inflationary pressure will not be sufficient to reach the inflation target over the next couple of years.

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Outlook 2017

Chart 20. Not enough wage growth expected

Chart 21. SEK expected to appreciate

Source: Mediation Office, Prospera

Source: Macrobond Financial

Chart 22. Oil prices quite flat

Chart 23. Electricity priced for slight decline

Chart 24. Riksbank priced to hike rates

Source: Macrobond Financial

Source: Nordpool Spot

Source: Macrobond Financial

Conclusion – what to expect from inflation and from the Riksbank in 2017 As mentioned above, the Riksbank’s rate announcement in December was seen as hawkish since half the board voted for no further, or a more limited, QE-extension. Nevertheless, the decision was to extend QE and to distribute re-investments of coupons and redemptions across the year. This implies that the RB will purchase another SEK31bn in nominal bonds in H1 (and approximately SEK16bn in H2). The ECB decision in December to extend QE to (at least) December 2017 was initially interpreted as too hawkish simply because it also decided to go back to monthly purchases of EUR60bn per month, which was taken as a sign of tapering, in fact the beginning of the end of QE. The initial market response was, however, short lived indeed and German 10year bond yields have retreated almost 20bp since. Presumably this is partly reflecting the fact that the market realises that the ECB is set to be present as a very substantial buyer of bonds for at least another year. There might be some parallels to make to Sweden. Admittedly, the Riksbank is likely to end QE substantially before the ECB, but it will remain in the market for another half year, absorbing more or less the entire gross supply. We think this will continue to restrict the upside primarily for maturities seven years and out for some time yet. But as we approach spring – say April/May – focus is likely to shift towards ‘life after QE’, something that could be a trigger for a re-pricing of ASW spreads that segment as well as curve dynamics. Furthermore, the Riksbank’s high attention to the krona is not only a matter of avoiding risks of future lower inflation in case of a rapid appreciation, but is also a way to ‘manage’ inflation expectations. That is a reason why we think it is wise to distinguish between future decisions of QE (in particular ending QE) on the one hand and the pace of rate hikes on the other.

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Outlook 2017

Swedish fixed income Q1 17 – the big picture We have for a long time argued that the Swedish curve is too steep out to the 5y segment relative to other markets. We do believe it will be hard for the Riksbank to ‘outhike’ the ECB in the fashion the market is currently pricing. However, short term, say during the first quarter of 2017, we expect domestic data to support the Riksbank’s idea that inflation is on an upward trend. We also expect this to take its toll on market pricing, at least relative to other markets, with the 5y segment underperforming. The Riksbank is likely to continue to stress the higher inflation rate, in order to underpin inflation expectation, despite the fact that higher CPI data will be driven by (we reckon temporary) factors such as petrol prices, taxes and the weak krona. Still we don’t see any sings of higher wage growth, i.e. the very core of domestic inflation, or any sign of a pick-up in demand-driven inflation (competition among retailers too fierce), see the section on inflation outlook for more details. We see a relative underperformance of the belly along the yield curve as temporary during the beginning of the year. Moreover, due to the steep curve out to the 5y segment, which we don’t believe will be sustainable, we avoid advocating steepeners, like 2s5s. Instead, we like to express the ‘relative bearish’ view on the Swedish 5y segment as a (relative) 5s10s flattener versus EUR, or outright. To offset the negative roll/carry in such a trade we still receive forward swaps in the very short end of the curve, or buy short-dated covered bonds. So, we start 2017 by focusing on being long SEK interest rate risk in shorter maturities, like blue and red FRA contracts, SEK 2Y 1Y or buying 3Y covered bonds (note that 3Y SHYP1583 offers best carry + roll down, +28bp over six months, along the covered bond curve). It is very important to stress that our underlying idea about Swedish inflation over the mid- and long term has NOT changed. Short term, however, inflation data (and possibly also macro data) is set to support the Riksbank and such market movements. In such a scenario, we expect Swedish 5y segment to underperform, especially if longer interest rates are more influenced by global rates. We see a clear risk that markets have moved a bit too far too fast by discounting favourable effects from the Trump administration. The US financial markets could be in for a ‘buy-on-the-rumours-sell-onthe-facts’ effect (timing wise it would mean after the inauguration of Mr. Trump). Amid elevated valuation of stocks relative to bonds (see charts below) this would, in our minds, result in lower stock prices and 10y yields, pushing 10y SGB yields lower and, as a result, a flattening of the 5s10s yield curve, at least relative to Europe. There a few other markets, beside the stock market, which have moved quite a lot after the US election. The charts below show a couple of examples that trade at stretched levels.

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Outlook 2017

Chart 25. S&P500 earnings yield vs. UST 10Y lowest since mid-2010 and taking 12M earnings estimates into account it is still low

Chart 26. 10Y UST 220bp above bunds

Source: Macrobond Financial

Source: Macrobond Financial

Chart 27. Forward market based inflation expectations have moved a lot recently

Chart 28. The 5s10s curve distorted by QE and negative rates – signs of higher inflation (albeit temporary in our view), support an idea of flatter 5s10s in Sweden

US 5y5y inflation swap EUR 5y5y inflation swap

2.6 2.1 1.6 1.1 Mar/14 Sep/14

Apr/15

Source: Macrobond Financial

Oct/15 May/16 Nov/16

Jun/17 Source: Macrobond Financial, Danske Bank Markets

In the last months of 2016, we saw higher yields supported by ‘Trump-expectations’. On top of this, the December Riksbank meeting indicated a hesitation to add more stimuli to the economy. This has affected 1-3y rates quite significantly along the Swedish yield curve. For instance, the money market slope 1y-2y normally moves together with the curvature of the yield curve but has over the past couple of months underperformed. We expect this to gradually correct and are more positive on the 2-3y segment than the 5y segment of the curve. Hence, we prefer doing roll down trades in the shorter maturities like SEK 2Y 1Y instead of further out on the curve. Chart 29. Relative steep curve 5s10s in SEK vs EUR –higher CPI (albeit temporary) could lead to a relative flattening of the SEK 5s10s curve

Source: Macrobond Financial

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Outlook 2017

Chart 30. The 1-2y segment has underperformed at the end of 2016 21



55 50 45 40

35 30 25 Jan-16

Apr-16

Jul-16

Oct-16

35 33 31 29 27 25 23 21 19 17 15 Feb-17

Source: Danske Bank Markets

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Outlook 2017

Further out on the yield curve, beyond 5-6y, the directionality in rates will be decided by global fixed income markets. Here we are more uncertain, but for the time being we think pricing has gone a bit too far too fast in certain market segments, like BEIs, 5y5y inflation swaps, yield spreads UST-Bunds and stock market valuations. The conditions for a rebound are in place given the stretched pricing in certain markets together with elevated surprise indexes. A ‘buy-on-the-rumours-sell-on-the-facts’ reaction when the Trump administration comes into office would not be a big surprise in our view. So, how would such a scenario impact Swedish yields and the shape of the yield curve? At the beginning of 2016 we witnessed a market move not unlike such a scenario when global rates rallied. A year ago the Swedish short end yields performed substantially and the curvature (2s5s10s) decreased significantly between year-end 2015 up to early March 2016. The curvature was more elevated when the bullish move started, see chart below, and the curvature now is only a few basis point above where it was in early March 2016. Is there a risk of a repeat should we see lower global interest rates in Q1 2017? Not in the same way as in 2016 we argue. At the February 2016 Riksbank policy meeting the repo rate was cut by 15bp and the terminal rate in their repo rate path was cut by another 10bp (i.e. in total a 25bp downward shift of the back end of the repo rate path). This, of course, supported the short end of the curve up to the 5y segment. We do not see any scope for such a move at the beginning of this year since inflation is set to be close to the Riksbank’s projection at the beginning of the year. Chart 44. The mid segment of the curve (5s) was supported by the repo rate cute 11 February 2016 – we don’t expect any such beneficial move first quarter this year 0 SEKFLY 2s5s10s

-5 -10 -15 -20 -25 -30 -35 -40 -45 Dec-15

Mar-16

Jun-16

Sep-16

Jan-17

Apr-17

Source. Danske Bank Markets

Hence, if global interest rates rebound a bit after the move higher at the end of 2016 we expect them to drag Swedish bond and swap yields down as well. The result would be a relative flattening of the 5s10s yield curve since we expect the 5y segment to be resilient due to a more ‘hawkish environment’ domestically. We don’t expect the very short end, up to 2-3y, to move in any significant way but will be supported by the steepness and the elevated forward implied TED spreads (see section above). Thus receivers in this segment can benefit from the positive roll down – in principle receiving in front FRA contracts, SEK 1y1y or SEK 2y1y would offset the negative roll in a 5s10s SEK flattener outright or relative to EUR (or possible NOK). A ‘fly’ where you pay 5y and receive SEK 2y1y and 10y would have a positive roll down of approximately 4bp over six months.

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Outlook 2017

Why do we not expect higher 1-3y yields given strong domestic data? The basic motive behind this idea is that despite a more ‘Riksbank friendly environment’, with relatively strong macro data and more upbeat inflation outcomes, will not only mean relief but also a stronger currency. Hence, in order to offset the stronger SEK during the year we expect the Riksbank to postpone rate hikes in its repo rate path again – instead of adding more QE or cut rates which the central bank will regard as unnecessary, at least at the beginning of the year. Chart 45. Relative steep curve 5s10s in SEK vs EUR – higher CPI (albeit temporary) could lead to a relative flattening of the SEK 5s10s curve

Source: Macrobond Financial

However, there is a potential flow that, if it materialises, could have a big impact on the SEK swap market. In the next section, we turn to this risk – if households in significant numbers move to fixed rate mortgages.

Trades Receive SEK 2y1y and pay 2y4y 2y forward. Buy SGB1059 and sell SGB1054 in a 5y10y curve flattener. Flatten 5s10s versus EUR or versus NOK.

Will households eventually move to fixed rate mortgages? This is a risk to monitor very closely going forward since it could result in a very large amount of payer swaps out to the 3y segment. So far we have not seen any indications of more households moving into fixed mortgages apart from some anecdotal stories in the media, but it is very hard to translate this into possible flows in terms of size and if only smaller amounts it could probably be managed by doing less of liability swaps when new bonds are introduced or tapped in the market. So what speaks in favour of more households (by significant size) moving to fixed mortgages? There are few arguments supportive for such a process. Risk management for households with less margins, the cost (in terms of monthly cash flows) of moving to fixed is very small. Perhaps the idea that flexible rates cannot get lower could be a trigger.

25 | 12 January 2017

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Table 4. What speaks in favour of/against households moving into fixed mortgages

In favour of sticking to flexible mortgages

In favour of fixed mortgages



It is still somewhat cheaper to have flexible (3m) rates.



Risk management for households with less margins,



Households have learnt that flexible mortgages have been better over time.



More or less completely flat lending rate curve between 3m and 3y.



The very substantial inflow into bank deposits could, at least to some extent, be households saving for days with higher mortgage rates (instead of moving to more expensive fixed rates) – this makes sense since it gives more flexibility to the borrower.



Mortgage rates will not decline further – bottom is reached.



It is very expensive to move to another bank if the borrower is tied up by fixed mortgages.

Source: Danske Bank Markets

However it is a puzzle that households with less of a margin have not already moved to fixed mortgages since they have been cheap for long, see chart below. The chart below shows only new lending but this should be a very good yardstick for the whole mortgage market since new borrowers should be the ones with tight margins and with an option. The major inflow to bank deposits that accelerated in 2016 (see next chart below) could have several explanations but one factor that could contribute is that households, instead of entering into fixed mortgages, stick to flexible mortgages and save money on the bank account for days when interest rates move higher. The major benefit from this (apart from cheaper today) is that the households avoid being tied to a bank. It is very expensive to move a fixed mortgage from one bank to another. Chart 46. The share of fixed mortgages (>

6 5

4 3 2

1 0 Sep-06

Jun-09

Mar-12

Dec-14

Spurce: Macrobond Financial

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-1 Sep-17

Outlook 2017

Needless to say, it is important to monitor any signs of a significant move into fixed mortgages. We expect potential flows stemming from households moving to fixed mortgages to hit the market and peak close to an end of a quarter. Most banks, in order to facilitate hedging with FRA contracts, roll their 3m flexible rates between the IMM dates. Being a payer at the short end of the swap curve is still very costly due to the steepness of the curve. Hence, timing is crucial and given that we still see no clear signal in data and history suggests households start to move when the first hike is delivered, we believe it is premature to take on trades that are dependent on payer swap flows on the back of households moving to fixed mortgages. However, given the view we have on covered bonds (see the section about covered bonds), we see value in buying 3y covered bonds in ASW spreads. Such a position offers carry and roll down over three months of about 3.5bp and the position would likely benefit from a move to fixed mortgages that trigger payer swaps in the 3y segment.

Trades Buy 3y covered bonds, SHYP1583 ASW.

Supply: first a new 10y bond – later the end of QE In Sweden, we will have slightly lower nominal bond supply, Riksbank is likely to continue to absorb all the supply. 

In Q4 16, nominal bond supply was cut from SEK3.5bn per auction to SEK3bn. This amount is expected to remain the same in 2017.



Some uncertainties remain regarding the underlying budget strength (primarily linked to the comparatively strong labour market) and the use of tax accounts as a deposit account.



The Riksbank is set to continue to be an important buyer with purchases totalling around SEK30bn in H1, and around SEK15bn in H2 (SEK15bn in new purchases and around SEK30bn in reinvestments).



In addition, the Riksbank is set to buy SEK15bn in index-linked bonds in H1 17.



New 10Y nominal and index-linked bonds will be introduced in 2017.

Despite decent GDP growth in 2017, the SNDO expects a swing to a SEK33bn borrowing need in 2017, owing primarily to outflows from tax accounts. Previously tax revenues have been boosted by a relatively attractive interest rate on money parked in the individual tax accounts. In January 2017, that rate will be lowered to 0%. The SNDO expects this to lead to outflows, boosting the external funding need. As some larger companies may experience negative rates elsewhere, it remains difficult to calculate the effect of the decrease in interest rate. The underlying improvement in the labour market continues to point in the direction of lower borrowing needs. In the meantime, the Riksbank announced on 21 December that QE would be extended by SEK30bn in H1 17 (half in nominal, half in real rate bonds). Also, maturities and coupon reinvestments (primarily holding in SGB1051 maturing in August 2017) would be spread over the whole of 2017, implying an unchanged QE pace in H1 (SEK45bn in total) and SEK15bn in H2. On a net basis, this will mean close to zero net supply in H1, and strongly negative in H2 due to the maturity of SGB1051. Arguably, these numbers could worsen further if the expected outflows from tax accounts fail to materialise (even though we think the SNDO is not keen to cut bond supply at this point).

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Outlook 2017

Table 5. Net issuance when taking the Riksbank QE purchases into account

Source: Riksbank, Riksgälden ((SNDO), Danske Bank Markets

Thus, to some extent, negative net supply after QE should continue to put a damper on SEK government rates. However, the Riksbank is also signalling that QE in government bonds is nearing the end. One board member voted against increasing bond purchases in nominal bonds, and two others saw no need for further stimulative measures. The risk is that at some point the market becomes increasingly focused on the end of QE. However, already in January a new 10Y nominal bond, SGB1060 (maturing 12 May 2018), will be introduced, 25 January 2017, with exchange-auctions in the following days. We expect this to have an effect on the market as the amount the debt office will buy back in SGB1059 is quite substantial, at least given the total issued size of the old bond and what Riksbank holds in that bond. Currently there is some SEK75bn issued in the bond and Riksbank holds SEK26.5bn of that nominal amount. If the switches are done in full, the issued amount would be decreased by SEK15.9bn. The Riksbank has announced that it will not participate in the switch auctions. The Riksbank’s holdings of SGB1059 as a share of total issued amount will jump to 45% from 35% if the switches are done to the full amount. Moreover, after the switches the preferred bond to issue will change. Over the past couple of years, the SGB1059 has been the primary choice of bond to tap. The SGB1060 will be the new preferred bond to tap after the inauguration. Hence, expect less issuance in the SGB1059. Meanwhile, the Riksbank holds more and more in certain bonds and in order to not hold more than 50% in these bonds it needs to purchase more long dated bonds in the 8-10y together with the 2y bond, SGB1052, in the first half of 2017. We also expect the 2039 bond to be bought on a few occasions (so far it has only been bought on two occasion). The switches will be supportive for the SGB1059 bond but the QE purchases in the first half of 2017 will also benefit longer maturities together with the 2y benchmark bond, SGB1052. The latter bond could also be benefitted by the redemption of the shortest bond SGB1051 in the summer. Hence, net supply, debt office issuance, redemptions and QE purchases should also support our idea of an underperformance of the 5y segment at the beginning of the year, at least relative to other peer markets. Moreover, we expect these forces to bring the current 10y benchmark bond, SGB1059, in more demand. We believe the recent underperformance of the bond vs swap has created a good opportunity to buy the bond in an ASW spread.

29 | 12 January 2017

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Chart 50. The recent tightening in SGB1059 ASW offers an opportunity to buy the bond ASW -30 -35 -40 -45 -50 -55 -60 -65 -70 Apr-15

SGB1059 ASW Jul-15

Oct-15

Jan-16

May-16

Aug-16

Nov-16

Mar-17

Source: Danske Bank Markets

Trades Buy SGB1059 ASW

Life after Riksbank QE However, later in the year as we approach the end of the QE programme, the long dated bond yields could suffer more, as the end of QE should promote a comeback of the term premia along the Swedish yield curve. A very easy and simple way to estimate the term premia is to use the Prospera monthly survey among money market participants. In the chart below, we show the results of a regression of the 2y, 5y and 10y bond yields together with the actual bond yields in the market. The regressions are performed on data up to February 2015, i.e. before the Riksbank starts its QE purchases. Hence, the model parameters have not taken the QE effects into account. The yields suggested by the model and the Prospera survey start to deviate a bit into 2015 for the 5y and 10y yield, whereas the 2y yields are still close to what the model implies given the latest Prospera survey. The four charts below show this phenomenon and to us it just confirms our previous thoughts that there is a clear QE effect mainly in the 7-10y segment of the government bond curve (can also be seen in the shape of the ASW curve) even though the 5y segment appears also to have been affected by the QE programme. The last chart shows the slope of the 2s10s government bond curve, which seems to trade a bit too flat given the level of the 2y yield. Hence, the QE effect is more pronounced further out (10y) on the Swedish government bond curve where the term premia seems to be heavily negative.

30 | 12 January 2017

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Outlook 2017

Chart 51. 2y bond yields in line with what the model and Prospera survey suggest 3

Chart 52. The 5y yields trade below the model- deviation some 65bp 3.5

2Y Yield Yield [predicted: Prospera Repo rate 2y, Prospera 2y infl.exp., CPIFY/Y]

2 1.5

Yield [predicted: Prospera Repo rate 5y, Prospera 5y infl.exp., CPIFY/Y]

2.5 2 1.5

1

1

0.5

0.5

0

0

-0.5

-0.5

-1 Oct-09

5Y Yield

3

2.5

Feb-11

Jun-12

Nov-13 Mar-15 Aug-16 Dec-17

-1 Oct-09

Feb-11

Jun-12

Nov-13 Mar-15 Aug-16 Dec-17

Source: Macrobond Financial, Danske bank Markets

Source: Macrobond Financial, Danske bank Markets

Chart 53. The 10y yields trade some 100bp too low in order to be line with the model

Chart 54. The slope of the 2s10s curve appears to trade is flat given the level of the 2ty bond yield

4

250

10Y Yield

3.5 Yield [predicted: Prospera Repo rate 5y, Prospera 5y infl.exp., CPIFY/Y]

3 2.5

200

-1.0%

2y/10y

0.0%

2y

1.0%

150

2.0%

100

2

3.0% 50

1.5 1

0

0.5

-50

0 Oct-09

Feb-11

Jun-12

Nov-13 Mar-15 Aug-16

Source: Macrobond, Danske Bank Markets

Dec-17

-100 Jan-98

4.0% 5.0% 6.0% Jun-03

Dec-08

Jun-14

Source: Macrobond, Danske Bank Markets

The negative term premia at the long end of the yield curve do result in very low real rates. BEI rates have remained stable or have been trading a bit higher. Swedish long-dated real rates are very low indeed. The 10y real yield spread to Germany is still negative, some 10bp, whereas the nominal bond yield spread is trading some +30bp. The market is already pricing a forward BEI rate between 5y and 10y very close to 2% (1.93% in the forward BEI between SGBi3102/SGBi3112, Dec 2020/Jun 2026). Hence, higher bond yields should, when they eventually arrive on the back of the end of QE, be driven by higher real rates in our view. Remember what the taper tantrum did to US real rates? See second chart below to refresh your memory. However, it is premature to take position for this given the QE, in our view.

31 | 12 January 2017

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7.0% Nov-19

Outlook 2017

Chart 55. 10y real yields trading well below the 10y nominal bond yield spread 80

10Y yield spread

10Y Real yield spread

60 40 20 0 -20 -40 -60 Nov-13

Jun-14

Dec-14

Jul-15

Jan-16

Aug-16

Mar-17

Source: Danske bank Markets

Chart 56. Remember what the taper tantrum in the US did for longer real rates? 10Y USREAL

1.4% 0.9% 0.4% -0.1% -0.6% -1.1% Apr-12

Oct-12

May-13

Nov-13

Jun-14

Dec-14

Jul-15

Source: Bloomberg

Trades There are trades to consider as we move closer to the end of QE, say in May/June, when we would look for curve steepeners, 2s10s and/or selling 10y real rates outright.

Covered bonds – index extensions should give some support Over the past couple of years, lending growth has in our view been a poor predictor of covered bond performance, for a number of reasons. One is that increased lending does not automatically translate into more domestic bond supply. Funding through deposits has grown substantially, and is likely to continue to do so in 2017. Foreign currency funding has also provided a useful safety valve. Finally, Riksbank QE has probably pushed some investors out of the government bond market into covered bonds, also affecting the supply/demand balance. Next year, domestic redemptions are rather limited, as was the case in 2016. However, there are large amounts of 2018 bonds, which will trigger significant index extensions. In the table below, we have estimated index effects given current volumes. In an environment where investors are likely to remain cautious, the market effect can be disproportionally large. Admittedly, the mortgage institutions are likely to use the increased demand surrounding index extension to issue new bonds. Overall, we do expect the net effect to be clearly supportive for spreads.

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Table 6. Significant index extensions during 2017

Index extensions in 2017 (Years) ALL MORT ALL BOND March 0.14 0.13 June 0.25 0.21 September 0.15 0.13 December 0.18 0.15 Source: Danske Bank Markets

Our fears regarding covered bonds are not so much focused on the housing market nor bond supply. We are more hesitant regarding the general rate environment. Volatility and/or higher rates would clearly be negative factors for SEK covered bonds. There is little indication that the Riksbank will provide additional support measures in the coming months. To some extent, the ECB decision to extend QE for a full year provides comfort, as there is a clear link to the EUR market. At the margin, mortgage institutions can channel some issuance into one or the other market depending on pricing/investor demand. Also, some investors are clearly looking across markets, further reducing the ASW spread differentials between different markets. Nevertheless, a renewed sell-off in USD rates would most likely lead to some spread widening. The recent spread widening coincides with the U.S. election. However, as soon as markets have shown signs of stabilisation, covered bond spreads have tightened again. Chart 57. Volatile markets usually unfriendly for covered bond ASW >

50

45 40 35 30 2016-05-10

2016-06-29

2016-08-18

2016-10-07

2016-11-26

2.6 2.4 2.2 2 1.8 1.6 1.4 1.2 1 2017-01-15

Source: Danske Bank Markets

Outlook for the housing market and effect of regulations Apart from having raised banks’ risk weights on mortgage borrowing in several steps, the FSA introduced a recommendation to banks to cap LTV on new loans at max 85% (2010) and a mandatory requirement for amortisation of new loans at a pace of two percent per year for LTVs exceeding 70% and 1% per year for LTVs of 50-70 percent. A study by the FSA (April 2016) shows that banks generally abided by the recommendation of maximum LTV and that they had started to adapt to coming binding rules of amortisation already before they were introduced. An update of the study will be published in April. As far as potential further measures to address the high pressure in the housing market are concerned, primarily two things are in focus:

33 | 12 January 2017

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Outlook 2017



A cap for loan-to-disposable income (LTI). From a technical point of view this would be a similar limitation to the LTV-cap already in use. Most banks already have internal rules for LTI but generally referring to gross income (600-700 percent) but a regulatory LTI (as it has been discussed) would be much stricter, relating to net (disposable) income and at levels not too different from the current internal gross LTI-caps. In principle, the FSA has the mandate to introduce an LTI but it would be a controversial decision with potentially large repercussions. Comments by the FSA suggest that an LTI – if needed – is not on the agenda until at the earliest 2018.



Reduced (or even removed) tax deductibility of interest payments. Currently, 30% of interest payments are tax deductible. At present ultra-low rates, the ‘nominal value’ of such tax deductions is small, but that would of course change if interest rates rise substantially and in effect magnify the cash-flow effects of interest rate movements. Such a change (since it concerns taxes) must be decided by the Swedish Parliament and is a hot potato. We don’t think any changes are on the agenda any time soon and in any case not this side of the 2018 elections.

So what is the latest impression from housing and borrowing data? Available information suggests that there has been some dampening effect on housing Chart 58. Housing, lower turnover and slower prices increases

Chart 59. Higher interest rates not a reason this time around

Source: Macrobond Financial

Source: Macrobond Financial

National data through Q3 indicate that turnover (one-and two family-dwellings) peaked around Q1 last year and has declined by about five percent over the preceding quarters, while at the same time the average purchase price of sold objects has levelled out. Other data sources like HOX-Valueguard quality adjusted price data for flats and houses show a similar tendency. This is also true for the most over-heated district, Stockholm, where the rate of price increases (for both categories) has decelerated from around 20% a year ago to currently about 5%. There may of course be many reasons why the housing market appears to be cooling off a bit. One observation, however, is that earlier episodes of price deceleration have generally coincided with higher (short-term) interest rates, like in 20072008 and 2011-2012 and/or higher unemployment. Higher interest rates can hardly be regarded as a dampening factor so far though. Finally, mortgage lending,

34 | 12 January 2017

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Outlook 2017

Chart 60. MFI lending to households, housing, %y/y

Source: Macrobond Financial

Monetary finance institutions (MFIs) lending growth to households for housing purposes had a cyclical peak of 8.7% in May and stood at 7.8% in November. That is not a very impressive change one may say considering that at that pace of deceleration, it would take another 2-2 ½ years to get lending growth in line with income growth. On the other hand (we claim), growth rates in lending are usually cyclically stable and the recent phase of slower lending has started in the absence of higher mortgage lending rates, which we take as a sign that the trend will prevail. Moreover, if there had been a clearly more abrupt drop in lending growth, we suspect that the reason would have been that a more disorderly correction (or worse) in the housing market had already started.

Covered bond supply in 2017 As can be seen in the previous section, the market is showing all the signs of a soft landing. Real estate prices have increased at a more subdued pace and lending is gradually decelerating. We expect that process to continue in 2017 with a gradual moderation in new lending. As we see it, the risk of a more disorderly development remains low under the current supportive environment: lending rates near record lows, continued employment growth and a general lack of housing in the major cities. Compared to other markets that have experienced a more serious downturn, Sweden stands out in a number of ways. There are few signs of lowered lending standards; rather the opposite, private savings are very high and the buy-to-let sector is close to non-existent. Barring any major macroeconomic shock, we expect a continued gradual decrease of net lending growth to the SEK175bn range, from around SEK210bn in 2016. In y/y terms this would imply a gradual decrease in the y/y rate towards around 6% by December 2017.

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Outlook 2017

Chart 61. We expect demand for house loans to continue to moderate in 2017

Source: Macrobond Financial, Danske Bank Markets

Gross issuance in 2016 was very much in line with 2015 despite lower redemptions. This resulted in significant buybacks of bonds maturing in 2017. Given that the volumes of outstanding 2018 covered bonds are large, we expect the mortgage institutions to be keen on buying back 2018 maturities through the course of 2017. Chart 62. Large amount of covered bonds maturing in 2018 outstanding (000s) LF Hypotek SCBC Nordea Hypotek Stadshypotek Swedbank Hypotek SEB

450 000 400 000 350 000 300 000 250 000 200 000 150 000 100 000 50 000 0 2017

2018

2019

2020

2021

2022

Source: Danske Bank Markets

Given the link between the SEK and EUR covered market mentioned above, a little more thorough discussion regarding the relative pricing is warranted. As can be seen below in the chart illustrating foreign issuance in SEK, the krona is far from becoming a funding currency. Despite owning close to 40% of the outstanding amount of SGBs, the Riksbank has struggled, for good reason, to keep up with ECB’s QE programme relative to the size of GDP. The sharp drop in foreign issuance in SEK reflects the unfavourable total cost of funding. Although the difference is slightly smaller for covered bonds, EUR funding remains attractive and is likely to translate into continued EUR issuance. Thus, from the issuer perspective at least, we would expect the flow picture in the EURSEK CCS spread to continue to be imbalanced, putting upward pressure on the EURSEK CCS spread curve in longer maturities.

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Outlook 2017

Chart 63. We expect foreign currency covered bond issuance to remain at similar levels in 2017 compared to 2016 (SEKbn) 120 Covered mdr SEK 100 80 60 40

20 0 Jan

Feb

Mar 2012

Apr

Maj 2013

Jun

Jul 2014

Aug

Sep

Okt

2015

Nov

Dec

2016

Source: Danske Bank Markets

On the back of a move in EURUSD CCS probably triggered by more USD issuance from EUR based borrowers, the 5Y EURSEK CCS has moved downwards (the usual correlation). However, this has occurred simultaneously as the short end of the curve has drifted upwards slightly, leading to flattening of the EURSEK CCS spread curve. Given the imbalance we hinted at above, we suspect that 5Y EURSEK CCS spreads could gradually drift somewhat wider in the beginning of the year on the back of EUR issuance. At the least, current CCS levels provide an incentive for the Swedish mortgage institutions to tap the EUR market, see chart below. Indeed, in early 2017, we saw two benchmark size issues from SCBC and Swedbank (as of 9 January 2017). Especially relevant is the competitive pricing in longer maturities. Redemptions in EUR look very much like last year, and the relative pricing vs SEK funding is equally supportive. We therefore expect similar volumes of issuance as last year, meaning a gross supply corresponding to around SEK90bn. Chart 64. Relative pricing in the EUR market still supportive for Swedish mortgage issuers, basis points SEK covered bonds

EUR bonds Swap to: SEK

50 40 30

20 10 0 -10 May-16

Sep-17

Feb-19

Jun-20

Oct-21

Mar-23

Source: Bloomberg, Danske Bank Markets

In the domestic covered bond market, net supply in 2016 amounted to SEK83bn. Gross supply totalled SEK385bn, which means relatively large buybacks of SEK94bn. Thus, the domestic covered bond market was used to fund less than half of the net lending. We think that one of the main reasons behind this low number is the multi-year growth in deposits. Domestic savings continue to a large extent to be channelled to deposits. In an environment where business investments remain subdued and banks are facing competition from capital markets, deposits have indirectly been funding housing loans. We see that the share of funding from capital markets for mortgage institutions has trended downwards for a number of years, with an increasing reliance on the mother bank (see chart below).

37 | 12 January 2017

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Outlook 2017

Chart 65. Y/y change in deposits (SEKbn)

Source: Macrobond Financial

Chart 66. Mortgage issuers steadily more reliant on funding from the mother bank 80%

70%

Share of bond funding Share of funding from certificates

Share of funding from mother bank

60%

50% 40% 30% 20% 10% 0% jan-04

okt-06

jul-09

apr-12

dec-14

sep-17

Source: Statistics Sweden

With no rate hikes in sight in 2017, we think deposit accounts will remain relatively attractive, as money market funds have given zero- or even negative returns in recent years. Thus, deposits should once again be used to fund expansion in mortgage loans. Overall, we expect the supply of domestic covered bonds to amount to around SEK365bn in 2017, a decrease of around SEK20bn from 2016. Combined with buybacks of existing short loans totalling SEK100bn, this would imply a positive net supply of around SEK50bn. Table 7. We expect slightly lower gross issuance in 2017 (SEKm)

Issuance Mln SEK Issuance Redemptions redemptions 2013 286 881 -205 874 81 007 2014 342 084 -207 910 134 174 2015 373 167 -279 081 94 086 2016 385 216 -207 770 177 446 2017* 365 000 -215 187 149 813 * Danske Bank forecast

Buybacks -64 312 -104 072 -48 221 -94 113 -100 000

Total net supply 16 695 30 102 45 865 83 333 49 813

Source: Mortgage institutes, Danske Bank Markets

38 | 12 January 2017

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Outlook 2017

Market view – we would avoid the 5y segment, buy 3y ASW Previously we have on occasion mentioned the remote possibility that the Riksbank could move to include covered bonds in the QE programme. With some board members even questioning the need for further stimulus, QE in covered bonds feels further away than ever. Something significant probably needs to happen with the inflation rate before the RB would look to covered bonds. At the very least, we do not expect speculation about QE in covered bonds to be a theme in H1 17. The supply picture we outlined above should be relatively well in line with investors’ expectations at this point. We do not therefore expect supply to be a major market mover this year. We have for a while argued in favour of longer-dated covered bond spreads. As 2016 was characterised by rate cuts and QE extensions, the hunt for yield was for a large part of the year a major market theme. In the coming months, we expect inflation outcomes to bounce around the Riksbank forecast, providing no clear guidance to markets. As covered bond spreads have tightened and we gradually approach the time point where QE expansion will come to an end, we are becoming less positive on the 5Y segment in general. We also keep in mind that covered bonds have performed rather consistently during 2016, and entry levels are now less attractive. Chart 67. Strong ASW performance in covered bonds in 2016 SHYP1581 ASW (Dec 2018)

SHYP1584 ASW (Mar 2021)

70 60

50 40 30 20 10 okt-15

jan-16

maj-16

aug-16

nov-16

mar-17

Source: Danske Bank Markets

We are therefore more inclined to take a more defensive positioning in early 2017. We prefer taking a position in the short end, 3y, where volatility should be smaller and the rolldown effect more supportive.

Trades Buy 3y covered bonds, SHYP1583 ASW.

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Outlook 2017

Kommuninvest interesting alternative to covered bonds Kommuninvest bonds performed relative to both swaps, covered bonds and SGBs in 2016. From time to time, during the year, expectations of Kommuninvest bonds becoming included in the assets that the Riksbank purchases in the QE programme have been mounting (and then fading). For the time being, there are no such expectations in market pricing. Still, the bonds have performed. One possible explanation behind this could be that we see more foreign investors buying Kommuninvest bonds, contrary to at least covered bonds, which primarily have a domestic investor base. Hence, covered bonds trade much in line with domestic investors’ general outlook of interest rates. This has become even more accentuated over the past year since many domestic investors have sold their holdings in government bonds to the Riksbank. Covered bonds are more of a delta-asset among domestic investors than a spread-to-govies (or swaps)-asset. So a possible explanation for the performance of Kommuninvest bonds is that the investor base is more diversified. For instance, Kommuninvest is a relatively well-known issuer in the US with a US benchmark programme. The chart below offers some support to this idea since the spread covered bonds over Kommuninvest tends to widen as the general interest rate level moves higher. Chart 68. The spread SHYP vs Kommuninvest tends to widen as rates move higher – is foreign investors’ involvement in Kommuninvest (but absence in SEK covered bonds) a possible explanation? 0.2%

SEGOVT 4y

Spread 4y SHYP vs KommInv >>

35

0.1%

30

0.0% -0.1%

25

-0.2% -0.3%

20

-0.4% -0.5%

15

-0.6% -0.7% Sep-15

Dec-15

Mar-16

Jun-16

Oct-16

Jan-17

10 Apr-17

Source: Danske Bank Markets

Moreover, the Kommuninvest bonds which are the bonds closest to government risk (apart from government bonds of course) in the Swedish fixed income market are trading relatively cheap vs swaps compared to the Danish peer, Kommunekredit. The 5y Kommuninvest trade, for instance, above swaps, whereas Danish Kommunekredit trades below swaps in the 5y segment, see charts below.

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Outlook 2017

Chart 69. 2y Kommuninvest (blue) barely below swaps, higher than Danish Kommunekredit

Chart 70. 5y Kommuninvest some 10bp above SEK swaps whereas the Danish Kommunekredit trades some 20bp below DKK swap

40

60

30

50 40

20

30

10

20

0

10 0

-10 -20 -30 Jan-15

-10

KOMINS 2.25 12MAR2019

Jul-15

Feb-16

KOMINS 2.50 01DEC2020

-20

KOM 2 01JAN2019

Aug-16

Mar-17

Source: Danske Bank Markets

-30 Jan-15

KOM 1 01JAN2021 Jul-15

Feb-16

Aug-16

Mar-17

Source: Danske Bank Markets

In addition, the Kommuninvest bonds trade at attractive levels if swapped into other currencies. The table below shows the ‘FX-carry’ (when doing a FX swap matching the maturity) and the effect for a foreign investor when swapped into their home currency. As an example, the 2y Kommuninvest bond, 13 Mar 2019, offers a 39bp pickup compared with an equivalent 2y US Treasury bond. Note, however, that peer assets in other currencies could trade even cheaper when swapped into, for instance, USD. Table 8. Kommuninvest, closest to Swedish government risk, offer pick-up when taking the ‘FX carry’ into account

Name

Yield

Maturity

FX carry

#N/A

#N/A

EUR

USD

GBP

Pick-up Yield bond

In EUR

In USD In GBP vs DBR Vs UST Vs Gilt

KOMINS 2.25 12MAR2019 -0.38% 12-mar-19 -0.08% 2.10% 0.94% -0.38% -0.45% 1.73% 0.57% 0.34% 0.39% 0.40% KOMINS 0.25 01JUN2022 0.52% 01-jun-22 -0.61% 1.75% 0.55% 0.52% -0.10% 2.27% 1.06% 0.41% 0.16% 0.39% Source: Danske Bank Markets

We are cautiously positive on Kommuninvest, as we have a relatively bearish view on the 5y segment, which naturally hit covered bonds since most issuance is done in this segment. The spread covered bonds to Kommuninvest is not at its widest but in a domestic driven sentiment we believe Kommuninvest could continue to perform relative to covered bonds in the 4-5y segment.

Index-linked bonds – BEI levels out of whack with expected rate hikes The US-led recent sell-off has not made much impact on SEK index-linked bonds on a real rate basis. The current 10Y index-linked loan, SGBi3112, trades at a real yield of around 1.3%. At first glance, it seems like a quite harsh investment option indeed. Invest SEK100 and receive a purchasing power equal to around 85% of that 10 years later. Despite a more hesitant tone from the RB about adding more stimulus, real rates are generally not far from lows. With a Riksbank signalling that the threshold for more support is likely to be higher, it could perhaps be argued that financial repression is likely to decrease, leading longer real rates higher. By comparison, since early November, both US BEI spreads and real yield levels have moved dramatically higher. After hovering around 0 during mid-2016, U.S. 10Y TIPS real yields have moved up to more than 0.5%.

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Chart 71. Both US real rates and BEI rates have moves higher recently >

0.8 215 0.7 205 0.6 195 0.5 185 0.4 175 0.3 165 0.2 155 0.1 145 0 135 -0.1 -0.2 125 dec-15 jan-16 mar-16 maj-16 jun-16 aug-16 okt-16 nov-16 jan-17 mar-17 Source: Danske Bank Markets

In contrast, both German and Swedish 10Y real rates are still trading below -1%, and not much above lows. However, spreads between Swedish and German linkers have risen significantly across the curve, see chart below. We find that reasonable, given that it could be argued that the Riksbank is closer to an end to QE than the ECB. Chart 72. SEK real rates have underperformed in the recent market movement 20

Generic spread 5Y SEREAL vs DEREAL Generic spread 10Y SEREAL vs DEREAL

0 -20 -40 -60 -80 -100 okt-15

jan-16

maj-16

aug-16

nov-16

mar-17

Source: Danske Bank Markets

However, just looking at real rates obviously gives a very incomplete picture. SEK BEI spreads have for the whole of 2016 traded at elevated levels compared to German BEI spreads, and this is set to remain the case, in our view. This relates not only to the strength of the domestic economy, but also to the influence of changes in monetary policy. In the coming years, expectations about future Riksbank rate hikes will be central for Swedish break-even spreads. Through the mortgage cost component, y/y CPI inflation should, once the RB starts to deliver rate hikes, overshoot significantly the 2% level, assuming that the RB refrains from rate hikes until CPI-F (which removes the mortgage cost component) lastingly reaches the 2% level.

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The nominal curves imply a string of rate hikes up to the 5Y point. Part of that may be due to increased term premia further out on the yield curve. Still, if a significant number of rate hikes are to be priced in, logically break-even spreads should trade way above 2% in the same time frame. Or the RB would implicitly abandon its 2% inflation target. We warn here against complacency. The inflation rate has risen, which to some extent has emboldened the Riksbank, but we see little signs of more broad-based price pressures, apart from energy prices and tax hikes. What is needed then to lastingly bring up the inflation rate? In our view, higher domestic cost pressures, primarily driven by higher wages. There are few signs that the ongoing wage round will result in significantly higher agreements than last year (for a more detailed discussion, see the section on inflation). This is in our view simply not enough to bring domestic inflation up enough to guarantee a total inflation rate towards the target rate of 2%. In the table below, we have adjusted BEI spreads by removing the effect of rate hikes priced in nominal curves, computing an implicit CPI-F BEI. We have assumed 25bp steps and a 100% pass-through between rate hikes and mortgage lending rates. Despite the rate hikes priced in, CPI-F expectations never reach 2%. Most notably, implicit CPI-F in the midsegment of the curve is relatively muted. Table 9. Implied BEI rates in CPIF terms – implied by current pricing of future Riksbank hikes

Bond SGB3107 SGB3110 SGB3102 SGB3108

Maturity Fwd BEIs - CPIF 2017-06-01 1.06% 2019-06-01 1.41% 2020-12-01 1.47% 2022-06-01 1.73%

SGB3109 SGB3104 SGB3111

2025-06-01 2028-12-01 2032-06-01

1.75% 1.92% 2.11%

BEIs CPIF 1.06% 1.34% 1.38% 1.47% 1.56% 1.66% 1.75%

Source: Danske Bank Markets

In the coming six months, we expect CPI-F to move around 1.5% y/y, albeit with some month-on-month volatility, with a high of 1.8% y/y in December 2016. Possibly this could lend some support to short end BEI. So here is another glaring market inconsistency – break-even spreads implying underlying inflation way below target coupled with nominal curves pricing a string of rate hikes. This is something we have highlighted in the past, but the rise in 5Y nominal rates means that it is once again looking quite stretched. One could consider going long BEI spreads in the mid-segment of the curve, such as BEI3102, to protect long duration positions in the short end. The ongoing RB bond purchases of index-linked bonds, extending into Q1 17 (SEK15bn), are an additional complication. Buybacks in index-linked bonds have at times been more unpredictable than in nominal bond auctions, with some buybacks occurring below screen prices. Given the generally more limited liquidity in the index-linked relative to the nominal bond market, some uncertainties will linger in conjunction with the buybacks. So at the moment it appears a tad risky to generally go short index-linked bonds. But later in the year, if we receive further confirmation that the Riksbank is moving towards the end of QE expansion, we may consider selling long dated index-linked bonds on an outright basis. But for the time being, we think it may be too early for this type of trade, given both continued linkers QE and the lack of confirmation of a broad based rise in core inflation.

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Finally, a few words about the new 10Y (SGBi3113, 1 December 2027) index-linked bonds to be introduced on 2 February. An ordinary auction will be followed by three switch auctions. In a context where other loans are bought back, it could be argued that the new 10Y loan should trade slightly cheap on the index-linked curve. The first buyback will be risk neutral against the second longest loan SGB3104 (December 2028) – note here that this loan trades way above par, with a clean price around 196. This means that despite the small difference in maturity, SEK3bn will be bought back against SEK5bn issued in the new loan (i.e. more inflation risk to the market). The following auctions will be cash neutral in SGBi3109 (June 2025) and SGBi3102 (December 2020, also here trading with a high clean price). Also here it will mean net issuance in nominal terms to the market. In a context where other loans are buying bought back, we find it hard to predict how much interest these exchange auctions will attract. Some index-trackers are likely to want to participate, but it will difficult beforehand to estimate whether the exchange auctions will be fully subscribed. We think that full participation in the exchange auctions should not be taken for granted and expect the new 10Y loan to be issued at a discount to existing loans.

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Disclosures This research report has been prepared by Danske Bank Markets, a division of Danske Bank A/S (‘Danske Bank’). The authors of the research report are Michael Boström, Chief Analyst, Michael Grahn, Senior Analyst, Marcus Söderberg, Analyst and Carl Milton, 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. The research reports of Danske Bank 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 a sensitivity analysis of relevant assumptions, are stated throughout the text. Expected updates None. Date of first publication See the front page of this research report for the date of first publication.

General disclaimer This research has been prepared by Danske Bank Markets (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 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 in this research report. 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.

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