Fixed Income Strategy

Fixed Income Strategy

3 May, 2024 Pär Magnusson, +46 (8)700 92 68, par.magnusson@swedbank.se

*This report has been prepared by sales and trading – non-independent research – only for professional clients*

*The views expressed here are the desk strategists’ only and do not constitute an official view from Swedbank*

Strategy Briefing
In brief
• The most interesting thing that happened this week was not the Federal Reserve meeting, nor
the non-farm payrolls report, but the Bank of Japan FX intervention. In this week’s Strategy
Briefing I explain why this is a potentially huge deal that we should all stay attuned to.
• The FOMC was hawkish as expected and EMU flash inflation came out on the high side. This
won’t keep the ECB from cutting in June, though. What happens after that is more uncertain.
Cost pressures are considerable in the EMU and if the ECB wants to see a series of low and
stable inflation readings before it cuts more aggressively, it may have to wait a while.
• The Riksbank is preparing to cut next week. There are good arguments to be made for why the
Riksbank ought to wait until the end of next month, but it seems the Riksbank is very keen to
cut in May. That said, risk-reward is decidedly in favour of buying the JUN24 SEK FRA outright.
• Any long positions in risk assets, positions for curve steepeners, or carry positions in covered
bonds vs. ASW should be hedged in either EUR/SEK FX call options or long SGBi BEI
positions.

The East is in the Red

You would be excused for thinking that the Federal Reserve meeting on Wednesday was the main
event of the week. However, in my opinion it was not. Rather, the most important development this
week was seen in Japan, where the Bank of Japan intervened heavily on the FX marker in order to
strenghten the JPY.

Let me explain why.

I will take a detour via the Riksbank before I get to the Japanese currency. The Riksbank has
requested a capital infusion of 44bn SEK from the government, as the Riksbank’s accounting rules
require capital adequacy to be restored after substantial losses in the Riksbank’s QE bond holdings. As
it happens, this idea that a central bank needs capital adequacy to be restored after having made
mark-to-market losses is a rather unusual one among central banks. However, the Riksbank evidently
views it as an important part of institutional credibility.

The ECB, or rather the national central banks that are responsible for buying bonds under the ECB’s
QE program, do not operate under the same requirement to restore capital adequacy. Instead, the
Bundesbank, for instance, simply adds an entry of “future profits” to its asset side in order to balance
out any mark-to-market losses on its bond holdings. This may seem like a bit of creative accounting,
but then again one can question the very concept that there is need for loss absorbing capital at a
central bank. For all practical purposes most central banks obviously do.

But even if you subscribe to the idea that a central bank doesn’t need loss absorbing capital and can
operate with negative equity, is there a limit to how much money a central bank can lose without its
institutional credibility being undermined?

Completed: May 3, 2024, 14:33 Please see important disclosures at the end of this document Disseminated: May 3, 2024, 14:33
Fixed Income Strategy
That is one of the most important questions there is right now, and it has become an increasingly
pressing issue for the Bank of Japan.

According to the latest data the Japanese government debt is 252% of GDP. The Bank of Japan
currently holds 53% of this debt, which is the equivalent of 134% of GDP. The Bank of Japan bought
bonds at a furious pace in the period 2013-2023, and starting September 2016 it also applied a policy
of yield curve control (YCC).

Why, you may ask?

The stated reason was to expand monetary policy further by anchoring monetary policy expectations
close to zero for a long time, but I believe there was an auxillary reason to this policy, which actually
may be much more important.

A central bank has a balance sheet with assets and liabilities. A central bank that has engaged in QE
will find that its asset side mostly consists of bond holdings, and that its liability side mostly consists of
deposits and cash issued (money in other words). Equity only makes up a small fraction of the liability
side. Especially at the Bank of Japan, where it is miniscule.
Fixed Income Strategy
Naturally, the asset and liability sides of a balance sheet must be of the same value. Consequently, if
the value of the asset side declines, so will the liability side. If there is loss absorbing capital on the
liability that is bigger than the decline in asset value, then there is no problem. However, if the loss on
the asset side is massively larger than any loss absorbing capital on the liability side, and there is no
intention of the owner of the central bank (i.e. the government) to infuse new capital, then what?

If you don’t what to find out what the answer to that question is, you may want to introduce a policy
where you make sure that the value of the asset side never declines below a certain level. That way
you will make sure that assets and liabilities can continue to grow without fear of calling the value of the
liability side into question. In other words, you introduce a policy of YCC that guarantees the value of
the bonds held on the asset side of your balance sheet.

Until you don’t…

And that is where we find ourselves now.

The average duration of JGB holdings at the Bank of Japan has been between 12-13 years in the last
five years. The volume of JGB holdings as been between 500-600 trillion JPY during this period. Since
the Bank of Japan declared that it will abandon its policy of YCC we have seen JGB yields rise by
around 100bp. A back-of-the-envelope calculation produces a mark-to-market loss around 60 trillion
JPY, or some 15% of Japanese GDP.

Sure, the Bank of Japan could make some imaginary entry of “future profits” on the asset side, but that
is hardly very credible if it at the same time keeps retreating from its YCC policy and thus pushes JGB
values lower. If the market loses faith in the value of the central bank’s asset side, and there is no loss
absorbing capital to speak of, then the natural conclusion is that the value of other items on the liability
side must fall.

To put it more pointedly: The answer to the question why a central bank can't simply write off the value
of its government bond holdings (as it is an entity of the same government, and thus give the
government debt relief), is that it would also write off the value of money on the liabiliy side.

If the Bank of Japan’s asset side falls in value, and there is no credible recovery in sight, the value of
money must also fall. Consequently, you would expect to see the value of the JPY to decline when the
value of JGBs decline.
Fixed Income Strategy

This may sound counterintuitive, as we usually associate a hawkish monetary policy with a stronger
currency. Indeed, the MPC of the Bank of Japan may have expected the JPY to appreciate as they
conducted a hawkish monetary policy at the same time as the rest of the G10 was on the brink of
cutting policy rates. Now that the opposite has happened, it could be a very serious warning sign of the
market losing faith in the balance sheet of the Bank of Japan!

Intervening on the FX market makes sense as an emergency measure, but it doesn’t solve the
underlying problem. Should the market reach a tipping point where it sees no credible way for the
Japanese government to fund itself in a sustinable way – assuming the Bank of Japan retreats as the
lender of first resort – the value of JGBs could fall sharply in value. This could in turn lead to a very
dangerous situation where the “fiat” of the Bank of Japan is called into question.

We are not there yet, and hopefully we will avoid such a situation altoghether, but it is a risk we should
be attuned to.

Should the depreciation of the JPY accelerate the Bank of Japan will likely have to reconsider its
decision to abandon the YCC policy, although it will come at a cost of credibility.

The fate of the Bank of Japan can also serve as a lesson for the ECB. If the ECB, which like the Bank
of Japan long has conducted a policy of guaranteeing the value of government bonds issued in the
EMU, ever tries to exctricate itself from that policy, it too may find itself in a predicament where will
have to defend the credibility of its balance sheet.

The ECB would to well to closely watch how the situation in Japan unfolds.
Fixed Income Strategy

Monetary Policy Easing…At Some Point

As expected, the Federal Reserve meeting on Wednesday produced a rather hawkish statement.
However, Jerome Powell did downplay any chance of hiking the policy rate, which the market received
favourably. (Oh how the times have changed…) The most important lines in the FOMC policy
statement were:

“Inflation has eased over the past year but remains elevated. In recent months, there has been a lack
of further progress toward the Committee's 2 percent inflation objective.”

…and:

“The Committee does not expect it will be appropriate to reduce the target range until it has gained
greater confidence that inflation is moving sustainably toward 2 percent.”

I find it hard to believe that any central bank can gain greater confidence that inflation is on target
unless it has a series of corroborating data. Not just one or two data points. This means that time is
running out for the Federal Reserve to cut policy rates before Q4, and the upcoming dot plots at the
June meeting will probably indicate a cautious policy path.

Speaking of entrenched inflation, flash inflation data for April in the EMU came out just above market
estimates. Core HICP rebounded higher on a seasonally adjusted monthly basis, which the ECB may
view as an indication that the proverbial “last mile” will be a bit of a struggle.

At any rate it did fit the narrative of a compromise June cut and then a wait-and-see stance. The
General Council really needs to find out if, and to what extent, cost pressures among corporates will
feed through to higher consumer prices. Just like the Federal Reserve the ECB may have to see a
series of inflation readings close to the 2% target before it will feel confident enough to lower the policy
rate by a substantial amount. I still like paying the front end of the EUR curve.

The Riksbank MPC will likely feel the weight on its shoulders as it meets on Tuesday next week. The
SEK has continued its depreciating trend since the last policy meeting in March, albeit appreciated
somewhat in the last two days, and it is evident that other central banks are becoming less prone to cut
rates. Still, the Riksbank has clearly communicated that it will cut its policy rate before the end of H2, so
cut it will. Either next week or in late June.

If the Riksbank goes through with a hike already next week, which is our official forecast, it will be a
novelty, as it will be the first time this century that the Riksbank begins a downcycle before the ECB
and the Federal Reserve. That this is done in a situation where core inflation above 2% makes it even
more unique. Still, this is a highly unusual economic cycle, and it is evident that both the Riksbank and
the ECB have decided to cut rates in anticipation of falling inflation rather than waiting for it to have
come down to 2% in yoy terms.

I persist with my view that JUN24 SEK FRA is cheap to buy and that risk-reward is in favour of
somewhat higher rates in the very front end of the money market curve. Fundamentally, there is a good
case to be made for a more inverted SEK FRA curve, with much lower rates in 2025 dated contracts,
but I am wary about selling those just yet. Eventually, we will probably get a “backloaded” series of rate
cuts, as central banks may let caution on inflation pressures push the economies towards a “hard
landing”.

What else is new? The big government bond index extension in Sweden will be done by the end of
next week, and there may be some laggards out there who still need to buy long SGB duration, but by
and large this should be over and done with. The squeeze in SGBs has abated a bit, as well it should,
and the SGB vs. ASW spreads will no be more dictated by the general risk sentiment. Seeing as I think
any hedges against a risk-off reaction in the financial markets are better made in EUR/SEK FX call
Fixed Income Strategy
options or SGBi BEI rates, I find it hard to see any real value in long SGB vs. ASW right now.

Covered bonds remain on the dear side, and while there still is some decent carry to be had in ASW
spread trades I continue to think it best to hedge any such positions with the aforementioned SGB BEI
or FX options.

To summarise my current trading recommendations:

• In the short term buy JUN24 SEK FRA to position for higher rates. Alternatively, pay 6m1y SEK
and hedge with 1m EURSEK FX call option 20 figures OTM

• Buy 2y SGBi3112 BEI @ 1.3%. This is a good hedge against steepeners and long risk asset
positions

• Enter a 2-5y SEK CB steepener vs. ASW flattener box trade

• Buy a 2y10 SEK swaption straddle vs. Sell the EUR equivalent

• Long only accounts that want to take a long duration position should buy 10y SGBi outright
rather than nominals

Swedbank Fixed Income Sales Contacts – Bloomberg SWEB

Marcus Cederberg, +46 (8)700 91 39, marcus.cederberg@swedbank.se
Olle Ringström, +46 (8)700 99 78, olle.ringstrom@swedbank.se
Camilla Nesvik, +46 (8) 700 95 26, camilla.nesvik@swedbank.se
Hanna Andersson, +46 (8) 700 98 17, hanna.c.andersson@swedbank.se
Mats Hydén, +46 (8) 700 98 05, mats.hyden@swedbank.se
Martin Kellgren, +46 (8) 700 98 04, martin.sven.einar.kellgren@swedbank.se
Fixed Income Strategy
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