Macro & FICC Research Published: 2020 12 11 06 48
SEB FI & FX Strategy
Reflation 2021 scenario gaining credibility
Summary:
In market focus. Restrictions; Vaccinations; Fiscal stimulus; Risk appetite; Brexit.
Global macro and risk appetite. Global macro has held up better than expected during the autumn but pandemic-related restrictions will weigh more on economic activity in late-Q4 and early 2021. However, the roll-out of vaccines and expectations of fiscal stimulus support a gradual return to normality and risk appetite going into 2021, lending support to our reflation 2021 scenario. BEI markets seem to agree.
USD rates: More stimulus from the Fed. Expect the Fed to shift its bond purchases towards longer maturities at the December 15 16 FOMC meeting on the back of downside risks to the economy and in order to alleviate upside pressures in long yields. Inflation expectations are expected to remain the key driver for higher long yields during the winter. We remain positioned for a steeper curve and wider long-end spreads vs.
Germany.
EUR rates: ECB to maintain current conditions. The ECB decision to keep the monthly QE purchases largely unchanged lends very little support to longer bonds while the increasing excess liquidity will keep the money market spreads at very tight levels. We regard risk/reward as attractive for tactical shorts in Mar21 Bund futures.
SEK rates: Tighter long SGB ASW spreads in January. Larger net SGB supply and seasonality should help to push ASW spreads in the long end tighter in January. Dovish Riksbank keeps the short SEK rates under pressure.
FX: Increasing fears of a no-deal Brexit a drag for euro in the near term. The general dollar weakness remains intact, but the risk of a no-deal Brexit will probably limit the further euro strengthening in the near- term. Wider XCCY basis ahead of YE has also lifted short EUR/USD forwards, that may limit euro buying interest in the near term.
Brexit: Only modest gains for GBP, even in a good trade deal scenario. The EU and UK leaders indicate a high risk of a no-deal Brexit as the Sunday deadline comes closer. Sorting out the future relationship does little to hide the underlying weakness in sterling.
Forecast revisions: More upside in US yields. We revise our mid 2021 forecast for the 10y Treasury yield from 0.90% to 1.10% and maintain upside risks to the forecast with a smaller revision to corresponding German and Scandi rates.
New feature: Summary of our macro views. Summary of macro, fixed income and currency views tables at the end of this report capture our key views in a nutshell. As a new feature, we have added a macro summary for the US, euro area, Sweden and Norway.
Seasonal greetings! With this year’s last edition of SEB FI & FX Strategy, we wish our readers a Merry Christmas and a prosperous New Year 2021! We will return to the usual biweekly schedule on 8 January.
Trade highlights:
- New: Buy put spread in Mar21 Bund futures.
- Sell SGB1062 05 2031) ASW (7 Dec)
Comprehensive list of trades at the end of the report.
Covid 19 vaccinations and fiscal stimulus hopes boost risk appetite
In the previous 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 coming year. Since then, risk appetite has continued to improve on the back of vaccine news and fiscal stimulus hopes, lifting US stock markets to new all-time highs.
On Tuesday this week, the UK became the first western nation to begin Covid 19 vaccinations with the Pfizer/BioNTech vaccine and the US is expected to start within days. The EU is likely to approve
Pfizer/BioNTech and Moderna’s vaccines on 29 December and 12 January respectively with vaccinations expected to begin soon afterwards. Even though restrictions and lockdowns will remain crucial for controlling the pandemic for months to come and will continue to weigh on economic activity, the rollout of Covid 19 vaccines is a game-changer for financial markets. Even though the shipping of millions and eventually billions of doses of Covid 19 vaccines around the globe will take time, it is generally expected that a majority of the population in the EU and North America will be vaccinated during the course of 2021. Prospects for a return to normality during 2021 renders the risk appetite much more resilient against softer data in the near term as the pandemic continues to surge.
In the US, the leaders of the Senate and the House have resumed negotiations on a fiscal package and we believe that both parties want to show progress ahead of the important Senate run-off elections at the beginning of January. The expiry of extended unemployment support by the end of the year and at the beginning of next year adds to the urgency to decide on new measures soon. Also, rising Covid 19 infections will increase the burden on small businesses in the services sector and the need for another PPP (payroll protection program) loan programme. After months of failed negotiations on the fifth pandemic package, hopes increased after a bipartisan USD 908bn stimulus proposal followed by the Trump administration, which on Tuesday presented a USD 916bn offer to the Democrats. House Speaker Nancy Pelosi (D) said that the Trump proposal represents progress, but “must not be allowed to obstruct the bipartisan Congressional talks that are underway.”
Surprisingly strong momentum in European manufacturing
In the macro arena, last Friday’s US labour market report was a disappointment. The sharp deceleration in jobs growth according to the November employment report signals that the pace of recovery in the labour market is clearly slowing and we see further downside risks for December and January. Also, indicators for mobility suggest a larger impact on the US economy than from the second wave during the summer and we have probably not seen the full extent in the data as states continue to add new restrictions to stem the spread of the virus. We foresee a soft message and more stimulus at the December FOMC meeting (more below).
Mobility: Retail sector/recreation, actual level vs. normal, 2020
In Europe, German factory orders 4 Dec) posted another positive month with annual growth returning to positive territory 1.8% y/y) for the first time since February. German industrial production data 7 Dec) confirmed last week's strong order statistics, leaving industrial production around 5% below the pre- pandemic level. Also French industrial production surprised on the upside 10 Dec) and Spanish production
9 Dec) fell less than expected. There were positive revisions to the September data for all of these countries.
Industrial production and retail sales
Altogether, October was a strong start to Q4 in Europe and with confidence indicators having held up better than expected, supported by high frequency data like mobility indicators, the signs are that the European manufacturing sector’s recovery continued in November.
German industrial production and trucking activity
Still, the ongoing surge in the pandemic is expected to increasingly weigh on the economic activity in November-December and with new restrictions in several EU countries likely to be introduced and probably remaining in place in early 2021, it will likely take a while before the real economic data turns better. For the reasons discussed above, however, this is less important for markets now.
Rising inflation expectations indicate the reflation scenario gaining credibility
With a successful reflation as our base scenario, we have foreseen an increasing upside pressure in long US yields in 2021. We have also been arguing that the Fed will allow long nominal yields to rise gradually as the recovery continues and as long as the increase in nominal yields is driven by rising inflation expectations (BEIs) rather than higher real yields. The more successful the reflation, the more long yields can be expected to rise. The recent positive vaccine news and prospects for further stimulus have already contributed to pushing the 10y Treasury yield from 0.50% in August to just above 0.90% currently.
Since early November, the increase in long US nominal yields has been driven by rising inflation expectations, which is in a strict contrast to August-October, when nominal yields went up as a result of rising real yields while inflation expectations were downbeat. The fact that the driving force behind the rise in nominal yields has changed is an indication of the reflation scenario gaining more credibility in markets. The recent downside pressure in real yields has contributed to the strong performance of the stock market. We think real yields are likely to turn somewhat higher during 2021, even though inflation expectations are likely to remain the main driver for nominal yields during the winter. At the same time when prospects for a successful reflation and a new fiscal package add to upside pressure in long USD rates, we expect the Fed to guard against yields rising too quickly.
10y real yields and inflation expectations (BEI)
FOMC December meeting: Shift in bond purchases towards longer maturities
We expect the Fed to maintain its dovish rate projections at the December 15 16 FOMC meeting with dots continuing indicating unchanged policy rates until the end of 2023. The lack of clear signals ahead of the December FOMC makes the outlook for the meeting somewhat uncertain, but we think the Fed is likely to shift its bond purchases to longer maturities due to downside risks to the economy and slowing employment growth, and in order to guard against the upward pressure in bond yields resulting from another stimulus package, which is expected to be presented soon.
The discussion in the November meeting minutes suggests that the FOMC is split with “several” members seeing limited scope for a more accommodative policy given already low levels of long yields while a few”
believed that asset purchases could help guard against upward pressure on yields from, for instance, higher Treasury issuance. We think it likely that the size of monthly bond purchases will remain unchanged (USD 80bn in Treasuries and USD 40bn in agencies) throughout 2021 and expect the Fed to more closely tie the life of the asset purchase programme to economic conditions and the start of rate hikes.
According to the November minutes, most participants favoured moving to a qualitative outcome-based guidance for the asset purchase programme, linking the life of the programme to economic conditions. Most participants judged that the guidance should imply that purchases would taper and cease “sometime” before the Fed begins to hike rates. If the Fed, as we believe, sticks to the projection from September with
unchanged rates up until end 2023, we think that the current asset purchase programme will continue throughout next year.
Interestingly, the Fed survey with primary dealers ahead of the November meeting suggested that the median respondent expected unchanged rates up until the end of 2023, but at the same time thought that tapering could begin already during in H2 2021 and continue until the first half of 2022. Compared to this, our forecast is more dovish. Read more in our FOMC preview here.
Forecast revisions: 10y Treasury to 1.10% in mid 2021, upside risks
As discussed above, US long yields will be facing opposing forces in the coming months with new fiscal stimulus and reflation pushing yields higher but with the Fed breaking the upside with a decision to direct its purchases more towards longer maturities. For quite some time, our mid 2021 forecast for the 10y Treasury yield has been 0.80 0.90% with upside risks. We now revise the mid 2021 forecast to 1.10% with upside risks if the reflation scenario continues to unfold the way we expect. With the 2y Treasury yield predicted to remain near current levels for most of 2021, this implies a continued steepening of the US curve. We prepare to revise our target for our existing USD 2y 10y curve steepener from 30 October accordingly (see levels in trades table below).
We also make an upward revision to our forecast for the German 10y yield, raising the mid 2021 target from 0.80% to 0.50%, implying an upside of around 20bps from the current level. As regards the risk spectrum, we foresee clearly more upside risks to our forecast to long US yields whereas the upside in German yields should be clearly more limited in H1 2021 even in a successful reflation scenario. Accordingly, we stick to our existing USD 10y vs. EUR 10y IRS widener.
Find our comprehensive forecasts here.
ECB extends, but does not expand, the current policy mix
At its monetary policy meeting yesterday, the ECB extended the Pandemic Emergency Purchase Programme (PEPP) by nine months to at least the end of March 2022 and increased its size by EUR 500bn to EUR 1.85trn. Additional long-term refinancing operations (TLTROs) were also introduced with very favourable terms.
The ECB is clearly concentrating on supporting the private sector lending by providing attractive funding for banks for longer, while asset purchases can be seen as a secondary tool where the ECB just aims to maintain the current flow of asset purchases to keep financial conditions unchanged. Indeed, ECB President Lagarde kept repeating in the press conference that the ECB aims at maintaining (i.e. not making more expansionary) the current financing conditions. However, Ms Lagarde noted that the PEPP envelope may not be used in full if financial conditions remain favourable, but at the same time the bank may also increase purchases if needed.
Regarding the euro, Ms Lagarde just noted that it is an important variable for the inflation outlook and the bank is closely following the developments in the currency markets. Read our more comprehensive analysis of the ECB meeting here.
As we expected, yesterday´s meeting did not offer any positive surprises for the markets. EUR/USD and interest rates increased and equities fell. The market still keeps pricing in some 10bps of rate cuts until end- 2021. The current QE programme does not lend much additional support to longer bonds, but rather secures that the longer rates remain close to the current levels until the market starts pricing in a brighter economic outlook. The excess liquidity will continue to increase, keeping money market spreads at very tight levels.
New trade: Buy put spread in Mar21 Bund futures
While we expect less upside in German long yields than those in the US over the coming months, we regard the current yield of the 10y Bund as stretched on the downside, and we expect it to fluctuate mostly in the 0.60 / 0.50% range in the coming weeks. Accordingly, we think the current squeeze renders risk/reward attractive for tactical shorts by buying a put spread in Jan 21 options (expiry on 23 Dec, 2020) in RXH1.
- Buy 177.00 put, 100 contracts - Sell 176.00 put, 100 contracts
Premium: 0.10 (levels as 10 Dec, 17.15 CET; RXH1 ref. 178.10). Delta: 0.14
At the expiry, the maximum profit occurs with RXH1 at 176.00 or below. The maximum loss is limited to the paid premium. The break-even at expiry is at 176.90.
Bought put spread: RXH1, strikes and German 10y yield
SEK rates: Tighter long SGB ASW spreads in January
Despite the large expansion of the Riksbank QE programme in November, the bank lowered its SGB purchases for Q1. The Riksbank will lower the share of SGB purchases to 11% in Q1 2021 compared with 22% in 2020 (including reinvestments). With only SEK 13.5bn in SGB purchases in Q1, while the NDO will issue SEK 30bn, the “free-float” will increase by SEK 16.5bn, which is the largest net increase since 2014.
The tightening ASW spread pressure, due to larger net SGB supply, is further supported by the usual SGB ASW seasonality, which indicates that we should see some 4 5bps tighter long SGB ASW spreads in January due to seasonality alone (read more here). The seasonal tightening in January is likely due to the large covered bond issuance activity and resulting in receiving interest in swaps. Although the budget surplus was surprisingly large in November, we don’t expect this to affect the SGB supply in the near term and the borrowing outlook is likely to remain unchanged in the next NDO borrowing forecast on 24 February.
However, we think the NDO is too optimistic regarding the budget deficit for the whole of 2021 and we expect more supply to be announced in May/June. The NDO is likely to continue to concentrate its issuance in the 10y segment and continue to build the volume in SGB1062 05 2031), where the outstanding volume is still only SEK 36bn. We expect the distribution to be quite similar to 2019, with almost 40% in SGB1062 and 60% in total in the 10y segment. We therefore recommend selling the new 10y benchmark SGB1062
05 2031), which is likely to experience the largest supply in January, vs. swaps.
Monthly seasonality estimates for SGB ASW 8y
Source: SEB
Brexit special: Differences might be too large to overcome for a deal
Note: The following text was written on 10 December, 15.00 CET. At the time of the writing, PM Johnson and the President of the European Commission Ursula von der Leyen had agreed to stretch a deadline to Sunday, 13 December. Later last night, PM Johnson said that the UK should prepare to leave without a deal.
Following the events over the past few days, both the EU and UK leaders indicate the likelihood of a deal being 50 50 or less. So far, we have stayed firm in our belief that a deal (a regular free trade agreement, FTA) is the most likely scenario, mainly due to the alternative being less economically beneficial for both parties, but particularly for the UK. However, while our assessment is based solely on economic pragmatism, these negotiations also include internal politics of principle in both the UK and the EU, a fact that in the end might be the most important one, and the one that creates high hurdles to overcome, even too high.
The UK wants as much sovereignty as possible in trade and in future decision making in general, while at the same time, with half of its trade with the single market, having as much access to it as possible. From an EU perspective keeping the single market intact, not letting the UK pick the best bits and at the same time fending off unfair competition not only now but also in the future, has been an important consideration for the negotiations. Despite fishing’s marginal economic importance, the access to British waters has turned into an important symbolic issue of sovereignty since the Brexit referendum.
Over the past few days, we have started to lean towards the harsh reality that perhaps it’s time to realise it’s better for both parties to start all over again, trading on WTO terms and accepting less trade and integration.
Then, without deadlines, the EU and the UK could start negotiating again to sort out unwanted negative effects. However, as usual with the EU deals, they tend to happen at the very last moment, and PM Johnson and Ms von der Leyen have agreed to stretch a deadline to the end of the weekend of 12 13 December, which means that the door is not completely closed yet.
The harder the divorce, the more pressure on fiscal policy. We have shaved off some 0.3pp from UK GDP in each of the coming few years in the event of an FTA while doubling the impact if no deal is struck. It is difficult to take a positive stance looking at the UK’s economic development. The budget deficit and debt levels are already high and more support will continue adding gilts to the market. Also, the UK runs a large current account deficit as a starting point. Trade will decline in both scenarios, although in the case of a no-deal a lot more. The net effect is hard to evaluate but EU importers can more easily than UK companies switch their suppliers to others within their free trading area. The lack of a broad-based manufacturing sector suggests the UK will have to continue to purchase many of its goods from the EU, hence widening the trade deficit. It is not unlikely that parts of financial and other services will move to the EU leaving the UK service trade surplus narrowing. It will likely take a while to attract FDI to cover up a most likely loss of FDI from EU members. From a monetary policy perspective, it is plausible that the UK will face higher inflation pressure in particular in the event of a no-deal as tariffs are imposed and sterling weakens. With such headwinds we believe likely excess inflation, in particular in a no-deal scenario, will weigh lightly as both monetary and fiscal policy need to step in to support the real economy. The BOE may well cut rates below zero in such an event.
A no-deal scenario would weigh even on the euro. To forecast where the pound will trade going into January 2021 is obviously very hard, but a few things are worth commenting on. Sterling is a popular long position for the next year as a bet on a trade deal and lowered political risk premium. Sorting out the future relationship between the EU and the UK is a step in the right direction but does little short-term to hide the underlying economic and fundamental weakness that sterling is facing. The UK has had a horrible year in terms of growth and budget developments, the current account deficit will likely increase and it is possible that the BOE has to introduce negative interest rates to support the economy. Neither is valuation as favourable as many seem to believe although it is clear that the pound is currently undervalued. The USD is in a downtrend and we think sterling will be partly dragged lower in this dollar weakening scenario. Without a deal, sterling will obviously decline but so should the euro. EUR/GBP will shoot up towards 0.95 before declining slightly again. EUR/USD will probably fall 1 2% and so cable is a better trade in a no deal scenario where JPY or USD vs. GBP or NOK offers the best short-term potential.
A deal would support sterling but we are less convinced it will be a one-way traffic from here so we would fade this move down towards 0.86 87 and then start looking at how the economy develops and whether the BOE will act again. We suspect the economy will continue to underperform making sterling vulnerable longer- term. As regards GBP/SEK we remain with forecasts showing sideways developments as also laid out in the latest SEK Views (Oct 2020). Given the external fundamentals and valuation, however, we favour SEK over GBP and would look to sell 11.40 50 for a move below 11.00.
Back trading with Santa: How did we do in 2020?
2020 has obviously been very difficult, but at the same time it has provided a lot of good trading opportunities due to high volatility. We entered 2020 with a cautiously positive outlook (Introducing 2020 trade ideas and trade themes, 12 December, 2019), but at the same time we highlighted downside risks in the mature business cycles and that the ongoing manufacturing recession posed risks for the global economy in 2020.
Rates: The surge of the Covid 19 pandemic in February-March changed the economic outlook and triggered massive market moves. Following the initial collapse in yields, our USD curve steepener, one of our international top trades for 2020, was stopped out in late-February.
In Scandi rates, the very flat SEK curve favoured to bet on a steeper curve going into 2020, but given the elevated global recessions risks, we were net long duration due to a higher risk weight in the short end in our steepener position. This eventually turned out to be very beneficial when global rates began to fall in February, especially in NOK, on the back of emerging pandemic fears. Since the Covid 19 pandemic broke out and money market spreads blew up, we were able to benefit from the inverted SGB ASW curve, recovering inflation expectations in Sweden and a tightening trend in EUR money market spreads as the market turbulence receded.
All in all, our official rates trade recommendations closed in 2020 generated a total profit of 57bps* with a hit-ratio of 55%. Excluding our recently published top trades for 2021, we have still seven positions open with a running P/L of additional 32.6bps.
* Note: For purposes of this summary, the total profit of 57bps has been calculated as a sum of P/L of individual trades irrespective of the DV01 of the position, reflecting the idea that a leveraged investor can basically scale up a position in a low DV01 instrument to match that of a high DV01 instrument. Furthermore, up until the launch of the SEB FI & FX Strategy report on 2 October, our official rates recommendations were focused on Scandi markets, whereas international trades were expressed as “trade ideas” and are therefore not included in the P/L summary here.
FX: For 2020, we recommended five top trades in the currency space. Despite the year turning out quite different from what we expected in December 2019, the top trades performed quite well with a total P&L of 4.6% with an average profit of 0.9%. The best trade turned out to be the one targeting weak GBP where the recommendation to buy EUR/GBP registered a 6.8% gain.
Our seasonality basket has not performed particularly well this year due to extraordinary circumstances caused by the pandemic that have overshadowed usual patterns. There is still a small unrealized profit of 0.8% to the seasonality strategy - the realised profit will be booked at the end of December when the December seasonal basket is scheduled to exit.
Finally, the very low volatility environment in early 2020 also provided an attractive opportunity to use the FX option market to buy some insurance for the tail risks, as discussed in Currency Strategy, 13 February (page 27).
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
Closed trade recommendations in 2020
Source: SEB
Jussi Hiljanen jussi.hiljanen@seb.fi
46850623167
Carl Hammer carl.hammer@seb.se
46703026128
Elisabet Kopelman elisabet.kopelman@seb.se
Karl Steiner karl.steiner@seb.se
46 70 3323104 Marcus Widén
marcus.widen@seb.se 46706391057
