Macro & FICC Research Published: 2021 01 08 06 55
SEB FI & FX Strategy
Surging pandemic meets the Blue sweep and vaccine hopes
Summary:
In market focus. Blue sweep; Fiscal stimulus; Vaccine roll-out; New Covid 19 strains; Lockdowns.
Global macro and risk appetite. Resilient manufacturing sector with manufacturing PMIs, increasing in December in most countries. Sharply declining real time service sector activity indicators on the back of new lockdowns in Europe while the US service sector continued to expand despite the worsening pandemic.
Vaccine-induced return to normality in H2 contested by new Covid 19 strains. Improved prospects for more US fiscal stimulus supportive to risky assets as long as bond yields remain in check. A major move higher in stock markets probably requires signs of a peak in the pandemic.
USD rates: Mounting upside pressure in the long end. Long real yields downbeat with rising inflation expectations. Expectations of additional fiscal stimulus adds to upside pressure in long yields. Sharp rise in spot inflation in H1 risk making markets increasingly speculating on tapering and early rate hikes, but will be downplayed by the Fed as transitory.
EUR rates: Time to scale into a Bund ASW widener. The market has reduced rate cut expectations, which now stand at around 5bps total until mid 2021. This together with the ECB taking the stance that the PEPP programme should be seen as a ceiling and not the definitive target is lifting the long rates from Q4 2020 lows. While higher rates suggest tightening Bund ASW, we believe that the improving German budget balance outlook will dominate and push the ASW spread wider during H1.
SEK rates: Steeper curve and tighter SGB ASW. Positive risk sentiment on the back of the Blue sweep and the sell-off in Treasuries are supporting our positioning in SEK rates as well. Moreover, the Riksbank’s Jansson said on 16 December that the bank may be approaching the limit on how much it can buy and a rate cut may be more relevant than QE going forward. The latest minutes also support this view. Our positioning with a steeper curve, short SGB 2031 ASW and receiving SEK FRA Sep21 fits in the picture very well. A rapidly strengthening krona also keeps the risks skewed to the lower short rates.
NOK rates: Take profit on NST482 2030) ASW widener ahead of the new 10y benchmark. NST ASWs remained surprisingly tight and stable during H2 last year and our anticipated widening did not materialise.
Now in December, after a massive NST underperformance vs. Germany, the demand for Norwegian government bonds increased sharply and the long ASWs widened by around 6bps. We close the position with a net profit of 8bps (incl. carry of 0.5bps) and look for some tightening ahead of the new 10y benchmark bond launch in February. From thereon, the usual seasonality suggests widening again towards the summer (read more on the seasonality here).
FX: Increasing US inflation expectations keep the dollar under pressure. A continued increase in inflation expectations, while the real interest rates remain low, is debasing the value of the dollar. This together with the Brexit deal, vaccine roll-outs and the outperformance of value stocks are likely to keep EUR/USD bid.
However, a material increase in Treasury supply expectations may eventually put upward pressure on USD real yields, which is a risk for our stronger EUR/USD outlook.
Introducing systematic contrarian strategy for G10 currencies. We have developed a systematic strategy for G10 currencies based on input from our short-term fair value models. The strategy is well suited to the current low volatility environment and has generated a return of 10.1% since its inception in June 2020.
Forecasts: Upward revisions to Treasury yield forecast. Following the Blue sweep and prospects for more fiscal stimulus, we revise our mid 2021 target for the 10y Treasury yield from 1.20% to 1.30% and maintain upside risks to the forecast. Find comprehensive forecasts here.
Trade highlights:
- New: Scale into long Bund Mar21 IMM start ASW at 30.5bps.
- Revised target: Pay USD 1y 10 vs. EUR 1y 10y 13 Nov); new target: 150bps.
- Revised target: Pay USD 6m10y vs. 6m2y 30 Oct); new target: 105bps.
Comprehensive list of trades at the end of the report.
Blue sweep and more fiscal stimulus amid pandemic headwinds
In SEB FI & FX Strategy, 27 November, we presented our outlook and top trades for 2021 with a successful reflation as our base scenario for the new year. Subsequently on 11 December, we argued that our reflation scenario is gaining credibility in markets, foreseeing the start of Covid 19 vaccinations and expectations of new US fiscal stimulus as key factors for increasing markets’ resilience against near term real economic headwinds amid the surging pandemic. Developments over the past few weeks have not changed our previous conclusions as regards the outlook for the new year but recent pandemic developments have certainly highlighted challenges on the way to normality. On the other hand, the Blue sweep in the US is improving chances for additional stimulus, which supports recovery prospects but also adds to the upside pressure in Treasury yields, which could turn harmful for risk sentiment unless kept in check. Buckle up for extremely interesting and potentially volatile coming months!
Another substantial US stimulus package expected
In the US, a long anticipated fiscal deal was finally reached on 20 December and signed by President Trump on 28 December. The package of around USD 900bn 4% of GDP) includes new support for small
businesses, direct payments to most individuals, extended unemployment benefits, and extra support for education, childcare and housing. The Democrats’ victory in Tuesday’s run-off elections in Georgia increases President-elect Biden’s chances of implementing his economic policies and raises the probability of more near-term stimulus.
With a unified Democrat Congress we expect Mr Biden to put forth another large stimulus package in Q1. This can be expected to include additional stimulus checks of USD 1,400 on top of the USD 600 included in the December relief package (estimated added cost USD 300bn or near 1.5% of GDP), extending expanded unemployment support measures through Q2, support for states and local government and, possibly, also some of the green infrastructure spending in Mr Biden’s 4-year, USD 2.2tn Build Back Better plan. Mr Biden’s election agenda also included significant tax hikes (USD 4tn over 10 years) but a narrow majority will limit the scope for major tax increases and in the current economic situation the focus will be on further deficit spending to speed up the recovery. Thus, another package of around USD 1tn 5% of GDP) is likely.
Prospects for increased fiscal spending were immediately reflected in the markets where the 10y Treasury yields jumped around 10bps after Georgia’s election result was confirmed. The Blue sweeps adds upside pressure on Treasury yields with supply increasing even more than previously expected while the bar for increased Fed’s bond purchases seems to be high. At the same time the pandemic adds to the uncertainty with potential to generate rapid market movements.
Vaccine-induced return to normality in H2 the base case but not without risks
A new, more contagious, mutation of the coronavirus was reported in the UK in mid-December and while there seems to be nothing to suggest that it would cause a worse disease or that recently approved vaccines would not work, it has triggered another lockdown in the UK. New restrictions have been introduced also across the continental Europe in an attempt to avoid the exponential rises in Covid 19 cases similar to that seen in the UK. For example Germany extended its nationwide lockdown on Tuesday by three weeks until end-January. In the US, the first case of the new faster spreading Covid 19 variant was confirmed on 28 December. While hospitalizations have hit new record highs in past days, generally speaking there is no major new restrictions introduced in the US over the past 1 2 weeks.
Covid 19: Daily change on confirmed cases 7d MA)
The EU Commission authorized the Pfizer/BioNTech Covid 19 vaccine on 21 December and Moderna’s vaccine was approved on Wednesday this week. Altogether, the EU Commission has a contract for more than 2 billion doses of Covid 19 vaccines with six pharma companies. Vaccinations in the EU began just before the New Year, but the pace of vaccine rollout has varied substantially between the European countries and has been generally speaking more lacklustre than hoped for, similar to that observed in the US. The US officials, however, expect vaccinations to gain pace with the authorities estimating that it may soon increase to above 1 million shots per day from around 500 thousand currently, matching president-elect Biden’s goal of vaccinating 100 million Americans within his first hundred days in office.
Temporary setbacks rather than derailment of the recovery scenario
For financial markets, additional US fiscal stimulus and vaccine rollouts add resilience against winter economic headwinds. The general consensus is that vaccinations will facilitate a return to normality in 2021 and such a scenario seems to be priced by financial markets. It is also our base case but uncertainty in the extent to which current vaccines will be effective against eventual new coronavirus variants constitutes a potential source of setbacks on risky assets for months to come. While it is estimated that current vaccines can be relatively rapidly modified to be effective even against new strains, the need to do so would likely slow down the vaccinations and cast additional uncertainty on how fast a return to normality can take place.
First days of the year, before the fiscal stimulus driven rally, indicate that markets are showing some anxiety about the uncertainty regarding vaccinations. While volatility indices (VIX, MOVE) jumped slightly at the beginning of the year, their levels remain low and the high yield market has remained calm. If the pace of vaccinations can be ramped up as expected and if the upcoming research confirms the effectiveness of current vaccines, setbacks in the financial markets should be relatively short lived rather than threatening the reflation scenario for 2021.
Altogether, we stick to our view discussed in previous editions of our biweekly strategy that real economic headwinds will increase in the near term with restrictions and lockdowns remaining the main vehicles for controlling the pandemic at least in H1 2021. Seasonal factors should ease the pandemic situation towards the summer and effects from vaccinations are likely to be felt in H2, hopefully avoiding new shutdowns during the autumn and thus facilitating a return to more normal life. Still, during the coming months the risk appetite is likely to be contested by eventual new Covid 19 strains and uncertainty over the timeline and success of vaccinations.
As regards global stock markets, our colleagues at SEB Equity Strategy maintain the positive base case for Q1 as long as long Treasury yields remain capped around 1% while a major move higher in stock markets would probably require some signs of a peak in the pandemic.
Low TIPS real yields depressing the dollar and supporting risk sentiment
Positively for the central banks, inflation expectations have remained on a gradual uptrend especially in the US, where the 10y real yield has declined quite substantially as a result since November to below 1.0%.
Most recently, Georgia’s election results pushed the real yield a few basis points higher.
The decline of TIPS real yields since early November has contributed to the recent dollar weakness and supported stock markets. As discussed previously, balancing the forces of the resilient real economy and reopening hopes, increasing long-end supply, continued QE and uncertainty about the pandemic, we think long US yields are likely to rise gradually in the coming 3 6 months, targeting the 10y Treasury yields at 1.30% in mid 2021 with a steeper curve. We expect this relatively modest rise to be driven primarily by a further rise in inflation expectations (BEIs), meaning that we foresee only a small increase in long US real yields from their current levels in H1. Such a scenario should continue to be positive for risky assets and negative for the dollar. As the scenario with a return to normality gains more ground, there is more upside in yields, possibly to 1.40 1.50% in the 10y Treasury by end 2021.
10y real yields and inflation expectations (BEI)
In Europe, we foresee a more limited upside in the German 10y yield, targeting 0.50% in mid 2021. With the short end moving largely sideways, such a forecast implies some steepening of the German curve and widening of the long-end spread vs. Treasuries. In a historical perspective our main scenario involves relatively minor changes in rates in the coming months, but assuming that our reflation scenario materialises, we see more upside in the US than in German long yields. In addition to the Treasury supply and expectations of the economic recovery as such, developments in spot inflation are likely to add to the upside pressure in the US yields by contributing to higher BEIs in H1.
Fed: High bar for more accommodative policy - no tapering in 2021
At its meeting on 16 December, the Fed clarified its guidance for asset purchases by promising to continue to buy “at least” at the current monthly pace of USD 120bn (incl. USD 80bn in Treasuries) until “substantial further progress” has been made toward the Fed’s maximum employment and price stability goals. Asset purchases are set to end before rate hikes start. As regards the policy rate guidance, the Fed expects to keep rates at zero until there is full employment, and inflation is at 2% and on track to moderately overshoot.
FOMC members do not expect to hit the 2% inflation target until end 2023 and median rate projections were kept unchanged at 0.1% during the entire period.
Minutes from the December FOMC meeting were published on Wednesday and suggest that participants are united behind the current very expansive policy but split on the need for further accommodation. A couple of members were open to shifting purchases toward longer maturities at the December meeting and some members thought the Committee could consider future adjustments if appropriate. If more accommodation is deemed necessary, buying more bonds of longer maturities is more likely than increasing the size of the program, but the bar for making policy more accommodative is fairly high. Minutes show that the Fed intends to guide well in advance before reducing its asset purchases. Thus, we continue to see tapering as an issue for the coming years and not 2021 (more here).
Rapid rise in US inflation may add to tapering and early rate hike speculations
Both the US and euro area inflation will rise quite substantially from very low levels in the coming months. In the US, core inflation will rise well above 2% driven by base effects with headline inflation likely to
temporarily climb to around 3%. The volatile US CPI during the spring and summer is explained by very large price swings on transportation services, accommodation services and clothes. The near-term outlook is
mixed with risks for further reversal of the low prices during the spring. At the same time, the crisis is creating downward pressure on PPI prices and wages. Rents inflation has continued to slow and a continued downward trend would have a large impact on inflation, which is a downside risk for inflation in 2021.
Inflation: Actual and SEB forecast
While underlying price pressures are low, a rapid increase of inflation in H1, especially if combined with additional fiscal stimulus in line with our expectations, could trigger markets increasingly speculating on earlier rate hikes and / or tapering. We maintain our positions for a steeper USD 2y 10y curve and a USD vs.
EUR 10y spread widener, both of which should gain on increasing UST supply and eventual tapering speculations. Following the strong performance , we change the target for the USD vs. EUR 10y spread from 140bps to 150bps and for the USD 2y 10y curve from 85bps to 105bps (see details in the table below).
Forwards on short USD rates have increased substantially over the past few days. For example, USD OIS 3y3m has advanced around 15bps in the past three days and 12m calendar spreads further out on the Eurodollar curve have steepened around 5bps.
USD OIS 3m & Eurodollar strip
In our view, an eventual near-term setback of around 5bps to the recent Eurodollar curve steepening (chart below) would render an attractive opportunity for fresh steepeners in anticipation of the rapid temporary rise in inflation. Also, currently at 99.775 (implied rate of 0.225%), selling EDU2 (Sep22) outright is a cheap option for positioning for more hawkish Fed expectations, even though it would take a quite substantial change in expectations to move that part of the curve to any notable degree.
Eurodollar curve steepness
EUR swap spreads: Improving German budget outlook to push Bund ASW wider
Bund ASW spread experienced a wild ride in H1 but stabilized at around 30bps recently. Our model, taking into account monthly changes in 1) the expected 12m German central government budget balance; 2) ITRX EUR senior financial 5y CDS spread; 3) level of German yields and 4) the slope of the curve, has been able to explain the monthly changes in 10y Bund ASW spread fairly well in 2020, other than for the month of April (the model estimation period is 2002 2019). In April, the public deficit was expected to explode but the Bund ASW barely budged (see the graph below). The reason for this is likely to be the lag in the economists’
estimates for the fiscal outlook as the estimates are collected very early in the month. Therefore, the April estimate relied heavily on the preceding month’s data. In March, the Bund ASW widened sharply during the first two weeks, which was rapidly erased once the ECB introduced the EUR 120bn QE envelope and the EUR 750bn pandemic program (PEPP), leaving the spread only marginally wider for the month. The wider deficit outlook showed up in April, which was old news for the markets by then and the shock was absorbed by the ECB. In normal circumstances the budget outlook moves slowly and such a lag is not a problem. Note that while there is no QE component directly in the model, the change in rates, the curve and the CDS spread include information about the QE.
10y Bund ASW model and factor contributions
Source: SEB
The budget outlook continued to deteriorate in May and June, which did capture the further ASW tightening nicely. Going into Q3 the economic recovery gained pace and the budget outlook started to improve (see also the graph below), contributing to the wider Bund ASW in September and October. At the same time market volatility increased ahead of the US election, resulting in a sell-off in credit risk and a rally in government bonds, which lent further support to the ASW spread widening. Altogether, we can conclude that the expected German budget outlook has been the major driver of the Bund ASW spread over 2020 and we expect it to play a major role this year as well.
10y Bund ASW and expected German budget balance 12 months ahead
Source: Consensus economics, Bloomberg, SEB New trade: Scale into long Bund ASW trade Buy Mar21 IMM Bund future vs. MM swap:
- Entry: 30.5bps (indicative as of 7 Jan, 18.00 CET); Half the standard risk size, look to add 28/ 26bps area.
Swap dates 10 Mar 2021 – 15 Feb 2030.
- Target: 40/ 45bps area - Stop: 24bps
- Roll-down: 3m roll-down is close to zero
As discussed above, we expect reflationary policies to support economic recovery this year, lifting inflation expectations and risky assets higher. This should lead to somewhat higher nominal rates, a steeper curve and lower credit risk premiums, putting tightening pressure on the Bund ASW. However, while these factors could drive the ASW spread somewhat tighter during the coming months, we find the tightening potential relatively limited. Instead, the improving forward looking German budget balance is likely to dominate over the tightening forces once the recovery gets going again.
The model estimates give us a framework to evaluate the rates and CDS impact on the Bund ASW until mid- 2021. Rates up to 5y are not likely to move much in H1, increasing probably only some 5bps. The German 2s10s curve could steepen by around 10bps and the 5y financial CDS spread could tighten further by 5bps.
These three factors together indicate only a 2bps tighter ASW spread according to our model (see the betas below). The budget outlook however, moving from 4% to 3% for instance, would imply 11bps wider ASW spread, leaving the net change in Bund ASW 9bps wider. We therefore see risks being skewed to the wider side and recommend scaling into a long Bund ASW position at 30.5bps. We allocate half of our standard risk exposure now and are looking to add to the position at around 28/ 26bps are, if we get there.
Model summary
Source: SEB
Introducing our systematic contrarian strategy for G10 currencies
We have developed a systematic strategy for G10 currencies based on input from our short-term fair value models. It is designed to take advantage of mis-valuations with focus on 1) high hit ratios, 2) frequent trades, and 3) short duration as the risk of noise to our signals increases with time. This strategy, where we are essentially scalping the market for inconsistencies, seems well suited for the current low volatility
environment and has generated a return of 10.1% since its inception in June 2020, which corresponds to an annualized return of 17.3% and an average monthly return of 1.4% with a positive return in all seven months (assuming equal investments in each signal).
Performance (since June 2020, %)
Source: SEB
Viewed as a stand-alone portfolio with a fixed allotment (assets under management) of which 1 6 (as there have been six currency pairs included in the strategy) is invested in each triggered signal the annualized return (excluding eventual return on the part of the portfolio not invested in a signal) would have been 4.0%
with a Sharpe ratio of 4.2 and still with a positive return in all seven months.
The strategy uses our short-term fair value models to trigger entry and exit signals and is updated daily while the control parameters (entry, exit, stop loss and take profit levels) are optimized on a quarterly basis. On average nine trades per month have been triggered with an average duration of six days. The short-term fair value is estimated using a three factor model using currency pair specific factors which empirically have proved to explain the currency pair best. At the moment all G10 currencies apart from the NZD are included.
This is because so far we have not found a mean-reverting property that works for the NZD.
The performance of the strategy will be followed in a table in this biweekly report (see the table at the end of the report) and we will also periodically update developments of the strategy in this publication. If you are interested in a more thorough presentation of the strategy and/or if you would like to receive the daily update, please contact Karl Steiner.
Summary statistics: Walk-forward back-test and live period
Source: SEB
Example of trade with entry and exit highlighted
Source: SEB
Real money value finder
The table below shows yields (YTM) in assorted countries in respective local currency government benchmark bonds and yields from SEK, NOK, DKK, EUR and USD investors’ point of view by accounting for respective currency hedge costs with the aim of providing investors in different domiciles an overview of FX hedged government bond yields. Note that actual relative expected returns over an investment horizon shorter than to maturity will crucially depend on spread movements.
Benchmark bonds: Yield to maturity, local currency and FX hedged
Source: SEB
Summary of macro, fixed income and currency views
Source: SEB
Open trade recommendations
Source: SEB
Systematic currency strategies
Closed trade recommendations in 2021
Source: SEB
Jussi Hiljanen jussi.hiljanen@seb.fi
46850623167
Elisabet Kopelman elisabet.kopelman@seb.se
Karl Steiner karl.steiner@seb.se
46 70 3323104
