Macro & FICC Research Published: 2021 05 28 06 56
SEB FI & FX Strategy
No taper, no tears - ECB to stay put in June
Summary:
In market focus. Tapering; Labour market; Inflation; USD money market.
Global macro and risk appetite. Manufacturing PMIs in the US and the euro area may correct temporarily lower in the coming months as reopening frictions ease, but the underlying trend for demand remains strong.
Near record low real yields will continue to support risky assets. Higher real yields later in the summer and autumn will be the signal for a clearer shift towards value stocks.
ECB unlikely to signal smaller purchases in June. Speculations on the ECB reducing its asset purchases run hot ahead of the June meeting. Despite recently higher weekly purchases, nominal rates and the euro have risen, while long-term inflation expectations remain well below target. With the inflation outlook still muted and risks associated with the near-term recovery, it makes little sense for the ECB to indicate tighter policy.
We expect President Lagarde to repeat that the PEPP is flexible and the bank aims to keep financial conditions unchanged. We see a clear risk that the ECB’s dovish message on 10 June could erase some gains in EUR/USD and moderate the rate hike expectations in the short end of the EUR OIS curve.
Euro area macro outlook: Too early for tapering. The recent strong hard data and survey-based indicators may lead the ECB to hold a slightly more positive tone at the June meeting, but revisions to the macro forecasts will be marginal. The service sector is recovering, but the full effect will not kick in until late Q2 or early Q3. We expect the ECB to make an upward revision to the inflation outlook, but the overall inflation profile will be relatively muted, and the upside risks remain highly uncertain and deemed as transitory.
EUR rates: Pay on dips. We have made a marginal upward revision to our forecast for long EUR rates, expecting the German 10y yield to increase to 0.10% (prev. 0.00%) by end 2021. We foresee positive reopening data and an increasing focus on the upcoming German election with expansive fiscal policy pledges by the Greens to lift long EUR rates during H2. In terms of the 10y Bund, we regard current levels near 0.20% as attractive for establishing fresh shorts, even accounting for our dovish stance for the ECB’s June meeting.
USD rates: Waiting game. Fed funds futures imply an around 60% probability for a rate hike by end 2022 and a change to Fed’s rhetoric is needed for them to move higher. A shift in Fed dots into a hawkish direction could also feed into rate expectations. We maintain our Q2 target range of 1.60 1.80% for the 10y Treasury yield and expect break-evens to recover from their recent decline, pushing long yields higher within the range. We stick to expecting a taper decision in September, which should help to lift the 10y Treasury yield at least to 2.00% during the autumn.
USD money market: Surging volumes in Fed’s reverse repo facility a potential concern? A massive increase in bank reserves parked at the Fed’s reverse repo facility and the decline in money market rates towards zero have gained increasing attention and raised questions whether it may jeopardise the Fed’s systems of steering money market rates and even add to systemic risks. We provide our take on the issue and conclude that an adjustment to IORB and RRP rates at the 16 June FOMC meeting seems likely.
Swedish krona: Change to AP7 investment guidelines could have material implications for SEK. The ongoing Government Committee of Inquiry on including AP7 into the same investment guidelines as AP1, AP2, AP3 and AP4 could mean that the fund will have to begin FX hedging its foreign assets, which would have a significant flow effect on the SEK.
Summary of our macro, rates and currency views. Tables at the end of the report provide a summary of our views for the US, euro area, Sweden and Norway in a nutshell.
Forecasts. Comprehensive forecasts here.
Trade highlights:
- Maintain EUR 2y15 vs. 2y2y steepener. Entered at 54.4bps on 22 Jan; Currently 80.1bps; Initial target of 85bps but more upside seems increasingly likely.
Comprehensive list of trades at the end of this report.
ECB is unlikely to signal lower purchases in June
Speculations on the ECB reducing its asset purchases at the June meeting run hot and according to the Bloomberg survey ahead of the April meeting, the consensus belief seemed to be that the next move regarding the asset purchases (in June) is for lower purchases. The whole discussion about reducing the purchases may have been lost in translation to some extent. The ECB announced in March that it will purchase “significantly” larger amount of bonds going forward and the weekly purchases have indeed averaged close to EUR 20bn during the past month, which is the highest this year. When Governing Council members talk about reducing the purchases, they may mean that the purchase pace could be “normalised” in June back to the levels before the March meeting. This is hardly a call for start winding down the whole QE program completely, which the word “tapering” usually refers to. Either way, given the increasing EUR rates and the value of the euro during the past month or so, the market seems to be discounting that the ECB could start signalling lower purchases at the June meeting.
ECB weekly PEPP purchases
The long EUR risk-free rates (OIS) increased during the past month, even though the ECB has ramped up the weekly bond purchases. However, inflation expectations have been rising faster than the nominal rates, which has resulted in real interest rates declining (on the discussion whether real or nominal rates matter for the ECB, see here). Given the upward pressure in EUR rates and the euro, we find it likely they will continue higher if the ECB starts signalling lower purchases in June. The US rates play a significant role here as the Fed tapering discussion is gaining pace (more below). We expect the Fed to start reducing its purchases in Q4, which would put additional upward pressure on long EUR rates. The ECB must take into account that the looming US tapering, or even a formal discussion about it, is a risk for the euro area financial conditions. The central question regarding the ECB’s asset purchases is if the inflation outlook has improved so much that it warrants the ECB to tolerate higher rates, which the bank is likely to get if it starts indicating an exit from the current policy stance.
EUR nominal and real risk-free rates
ECB is likely to be retro- rather than pro-active
There seems to be a clear division between the north and south within the Governing Council, with the northern national central banks more eager to scale down the asset purchases as soon as the worst pandemic phase is over, while the south would like to postpone any tightening well into the future.
Lockdowns still persist in some parts of the euro area and the low percentage of the vaccinated population restricts the service sector output and employment (read more on the macro and inflation picture below).
The vaccinated people are likely to be allowed to start travelling soon, but the service sector can be expected to fully normalise only when the Covid 19 vaccine coverage target of 70% has been reached and tourism gets fully going. Currently, the 70% vaccine coverage is expected to be reached in mid-July (at the earliest in our view). As of now, some 40% of the euro area adult population has received at least one vaccine dose.
Therefore, if the ECB, in line with the Fed, wants to see a string of strong hard data before it feels comfortable accepting tighter financial conditions, the June meeting seems too early for any tightening signals. In our view, it makes very little sense for the ECB to deliberately communicate that it intends to reduce the PEPP purchases in June and get ahead of the Fed in the policy exit process while the euro area economy
significantly lags the US. While the staff projections are likely to be raised somewhat in June, there is still high uncertainty on how the recovery will play out. By September there will be significantly more important data available regarding the pandemic and the service sector output which would allow the ECB to better ponder the current policy stance.
Inflation expectations give no reason for complacency
It is also worth noting that inflation expectations, according to inflation swaps, indicate that the market expects the annual inflation rate to stabilise no higher than at around 1.6%.
Annual EUR inflation rate priced by the market
Source: Bloomberg, SEB
Survey based measures are not that far away from the market-based measures.
Survey of professional forecasters: Longer-term inflation expectations
Source: ECB
At the same time the market expects, according to the OIS pricing, that the ECB would deliver the first 10bps hike in Q2 2023. This is another aspect that should make the ECB cautious in terms of its communication. If the market is not convinced that the ECB will reach the inflation target in the long-term, the ECB should refrain from indicating any tightening plans. In our view, there is no room for the ECB to get complacent at this point and we expect it to stick to the “unchanged financial conditions” narrative until the bank can see the service sector normalising and inflation expectations back, or even above, the target. The ECB signalling lower purchases at the June meeting would be a sign to the market that the bank feels comfortable with tighter financial conditions, which is likely to lead the market to extrapolate that development. President Lagarde is likely to tackle questions regarding the plan to reduce the purchases by saying that the purchases continue in a flexible manner and the ECB aims to keep financial conditions unchanged.
Expiring TLTRO terms also pose a challenge, especially if it coincides with tapering
Approximately half of the excess liquidity in the EUR comes from the TLTRO III (EUR 2,079bn out of EUR 4,117bn). The TLTROs are currently designed to give the EUR banks a strong incentive to use the TLTRO facility to the largest extent possible. Banks pay a very low interest rate, the deposit rate minus 50bps on these, and they can post illiquid collateral against the TLTRO borrowing, due to the temporary ease of the terms. Both the possibility of the attractive rate and the temporary collateral terms are currently set to run out in June 2022. For this reason, we expect the TLTRO liquidity to stay in place until then and liquidity will continue to increase as the ECB asset purchases accumulate more excess liquidity every day. Hence, we do not expect any changes to the suppressed 3m and 6m Euribors in 2021 and the large part of 2022.
The question for 2022 remains to what extent the ECB will feel comfortable tapering its QE and rolling back TLTROs at the same time? While the TLTROs in principle are 3y loans, the borrowing banks have the option of quarterly repayments (from September 2021 for the first seven operations, and from June 2022 for the last three), hence if the ECB tightens the terms of the TLTROs, there is a real risk of repayments.
On top of this the TLTROs in their current shape is a subsidy to the banking sector to make up for the side- effects of negative rates. By reducing this subsidy there will be a need to increase another subsidy to prevent the cost for the banking system from increasing. In other words, if the ECB increases the rate it lends to the banks, it should allow the banks to place a larger amount of excess liquidity in the deposit facility at the 0%
rate in order to keep the aggregate costs unchanged. However, this would in effect tighten liquidity as more liquidity in the deposit facility would not be available for lending in practice. Tapering both QE and TLTROs at the same time could thus turn out to be an intricate walk on a tightrope, leading the ECB to take a more gradual approach keeping the terms of TLTROs attractive for an extended period while tapering the QE.
Furthermore, the ECB’s strategy review could very well result in including TLTROs in the ECB’s ordinary monetary measures, which will add to the legitimacy of keeping the TLTROs in place for a longer period and thus keeping money market spreads subdued for a longer period.
Euro area economic and inflation outlook: Too early for macro to say yes to tapering
The hope for normalisation is rising as economies start to re-open in the wake of falling infection rates as vaccinations are speeding up. In areas like manufacturing and retail, we have already seen a recovery and resilience to the latest waves of the pandemic. However, the parts of the service sector that are still lagging are the ones that have been most affected by restrictions. In our view, as a likely substitution back to service consumption once economies open up, some supply side problems might occur. This is not only in the manufacturing sector but perhaps also in the service sector, which will show the most prominent source of a rebounding force in the short-term. The persistence in small and/or major bottlenecks are key, not only for the recovery itself, but also for the inflation outlook.
Covid 19 vaccinations: % of population having received at least one shot
Note: Slightly over 20% of the population (taking EU as an example) is below 20 years old and those are in most cases excluded from the groups that are vaccinated, at least for now.
Going into the June ECB meeting, the recent strong hard data and survey-based indicators might lead the ECB to hold a slightly more positive tone regarding the economy, but revisions to the macro forecasts will, in our view, be marginal and not warrant tapering. There are setbacks risks, and the re-opening process in many countries is taking a step-by-step approach, as long as vaccinations do not cover the clear majority of the population. Central banks and politicians have used all available tools to avoid an even worse economic development over the past year and we believe that the ECB would like to see more solid proof of a stronger recovery before taking steps towards tapering. Looking at the mobility data and news for easing the restrictions in the euro area economies, there are clear signs that service consumption will boost overall demand and GDP. That effect will probably not kick in until late Q2 or early Q3 and hard data for those months will not be available for the ECB in June. There are still uncertainties about how large and persistent the rebound in services will be, and to what extent the sector will be able to ramp-up production in the short- term. Given that some restrictions will continue to make service consumption more difficult than normal, overall supply in the most affected services sectors will probably be below pre-pandemic levels for some time.
Mobility indicators: No significant rise in services before the June meeting
Tourism could be the positive short-term surprise. The southern European countries took a relatively large hit during the past year, partly due to the dependence on tourism, both on a gross and net basis. Dependence on tourism varies depending on the measures used and among the major four economies, tourism is especially important for Spain, Italy, and France. Monthly data on travel is still depressed but is lagging and not catching the uptick currently reported by various news agencies. Furthermore, the EU agreements on a passport to allow for travel if vaccinated, the presence of antibodies, or a recent negative Covid 19 test, is expected to
contribute to a tourism-driven summer, which is clearly stronger than last year but it is still difficult to see full normalisation in the short-term. Overall, there are possibilities for short-term positive surprises in the service sector, but the ECB is likely to be cautious in getting too complacent about the early reopening news.
International arrivals
Higher inflation, but most likely not moving the ECB
The rise of global inflation has taken the centre stage in 2021. While we see several counterarguments to be valid, not only in Europe but also in the US, we view the current reflation trade debate to be more plausible in the US, given that the US economy is closer to a point in which overall strains in the labour market may create a more persistent upward pressure for wages. However, there are several arguments that suggest an upcoming period of excess inflation will prove to be transitory, in most economies.
Firstly, by most historical metrics, a sudden surge in commodity and freight prices have had a relatively modest impact on core inflation. This is primarily explained by the fact that those prices have been mean reverting with a less clear upward trend. Furthermore, the value of any intermediate goods is a relatively small share of the final value of many consumer goods.
Secondly, no matter how you view the fundamentals behind higher inflation, you end up in the underlying trend of wages and labour market being of key importance. Despite the possibility of short-term bottlenecks as the economies re-open, we still believe that there will be some slack in the EU labour market in the coming years.
HICP ex energy, food, tobacco & alcohol (highs and lows for assorted individual countries)
Signs in the previous months of distorted supply chains should also be transitory as ramping up production is often just a matter of time, albeit a year or so. However, the central question is how demand will affect the regular modest pricing patterns. We are humble before the fact that the scale and speed of pent-up demand is larger than we have ever seen before. But once again, it all depends on the persistence of price dynamics. If
a short-term excess demand will create pull-inflation, any likely scenario of getting back to a normal distribution of demand suggests part of that pull-inflation will be reverted. However, if demand is deemed structurally higher in specific areas, prices will (and should) stay higher for a longer time. But this would most likely come at a price of more modest price increases in sectors which are negatively affected by any medium-term change in demand. The risk for inflation lies primarily in whether bottlenecks in service sectors prove to be more persistent and if labour supply has drifted away from the sectors most heavily affected by the pandemic. If such sector rotation of labour supply creates a more broad-based wage drift higher, the corresponding price implications cannot be deemed as transitory.
All this being said, we obviously see the arguments for temporarily higher inflation, and acknowledge the test for the central banks to stay put in the analysis that most parts of inflationary pressure will be transitory. The higher the short-term rise and/or the longer the temporary upward pressure remains, the more difficult the central bank will have to completely overrule any action.
Upward revision in the ECB’s inflation profile, but no changes to the policy stance
In terms of the ECB staff projections, we believe the June report will present an upward revision in inflation numbers by some 0.2pp in 2021 and 2022 while only 0.1pp in 2023. Since the March projection,
international and commodity prices have continued moving higher. International food prices have some time lag and hence we expect the current low HICP food inflation to turn higher starting in the coming months, peaking in H1 2022. The higher than expected core inflation reading still stems from abnormal seasonal patterns in both goods and services, in particular in the major economies. From the summer onward, core inflation will turn swiftly higher due to various base affects from 2020. Next to these short-term dynamics, past months’ real economic developments in both the euro area and its main trading partners have moved towards the ECB’s mild scenario laid out in March, suggesting an upward revision in inflation. Accordingly we believe the bank will take a step in changing the inflation outlook upwards, but the overall inflation profile will be relatively muted. However, inflation numbers will be highly volatile and our peak reading for headline HICP is almost 3% y/y in November 2021, from the April 1.6% reading. We also expect the ECB to stress the upward risk mentioned above due to the rapid rise in demand, although its persistence remains highly uncertain. We still see that the ECB will view this as transitory, as mentioned above.
Headline HICP: Higher due to base effects
USD rates: Waiting game
The past two weeks have shown renewed downside pressure on long Treasury yields with low long real yields, inflation expectations turning lower, and the dollar remaining under pressure. The key event next week will be the US labour market report for May, not least considering the major disappointment in April payrolls. Inflation data for May is due on 10 June, just ahead of our next SEB FI & FX Strategy biweekly.
Fed minutes from the 27 28 April meeting were published on 19 May and suggest that some members were getting ready to start talking tapering at the “upcoming meetings”. The minutes also show that members were becoming more concerned over inflation. A “number” of participants saw risks that supply chain bottlenecks and input shortages may not be resolved quickly, and if so “could put upward pressure on prices beyond this year”. These members also noted that supply chain disruptions appeared to be “more persistent
than originally anticipated” in some industries and that this had led to higher input costs. A “couple” of members commented on risks for inflation pressures building up to unwelcome levels before a policy reaction. As regards the labour market, “many” participants remarked on businesses having trouble hiring workers due to both early retirements and pandemic-related causes, suggesting that labour shortages in April should not have been a complete surprise (read more in “Fed was moving closer to tapering in April”, 19 May).
Moving towards taper talk. Several more recent comments by Fed officials suggest that policy makers seem to be approaching a point where they will be ready to start discussing tapering of bond purchases that have been stable at USD 120bn per month since last summer. On Tuesday this week, Fed’s Vice Chairman Clarida said that the bank can begin to discuss tapering in “upcoming meetings” and his comment were echoed by Fed's Quarles at the Brooking Institute webinar. Mr Quarles said that high inflation is temporary, but risks are on the upside. He also said that the labour market is still weak but that “If my expectations about economic growth, employment, and inflation over the coming months are borne out, it will become important for the FOMC to begin discussing our plans to adjust the pace of asset purchases at upcoming meetings.” He also noted that “substantial further progress” in the labour market, which has been set as a threshold for the Fed to change its course, is posing a communication challenge due to its vagueness. Mr Quarles said that the Fed may need to clarify that.
We stick to our view that the Fed will begin taper-talk during the summer, ahead of an actual decision in September. Prior this, another shift of Fed dots into a hawkish direction at the 16 June meeting would be a potential trigger for turning short rate expectations somewhat higher again, after the decline seen since end- March. Currently, fed funds futures discount an around 60% likelihood for a rate hike by the end of the next year. As we have discussed before, we think rate hike expectations will move largely sideways up until the Fed changes its rhetoric which as such supports our view of range-bound long rates in Q2.
Fed funds Jan23 implied rate & implied probability for a 25bps hike by end 2022
In the long end of the curve, we maintain our Q2 target range of 1.60 1.80% for the 10y Treasury, implying some modest upside potential in yield from the current level of around 1.60%. We regard the recent 10- 15bps decline in the 10y market-based inflation expectations (the 10y TIPS BEI is currently around 2.45%) since mid-May as temporary and think that inflation expectations will return back to their recent highs in the coming weeks but not necessarily rise more than that, especially if markets continue to price the Fed taming inflation pressures by hiking rates clearly earlier than its current communication suggests.
With long nominal yields expected to be lifted by slightly higher inflation expectations, we foresee the 10y real yield to see only negligible upside from current level of around 0.90% in the near term, which should continue to lend support to risky assets and weigh on the dollar to the summer. Our 2.00% end 2021 target for the 10y Treasury yields means that we foresee some increase in the real yield in H2, which will likely support the dollar and weigh on growth stocks.
USD money market: Surging volumes in Fed’s reverse repo facility – a potential concern?
The past few months have seen an increasing downward pressure in USD money market rates as bank reserves, or federal funds, have continued to increase, mainly as result of the Fed’s bond purchases but also due to other factors that we discuss below. Since early April, the usage of the Fed’s overnight reverse repo facility (RRP), a place to park idle reserves, has increased sharply and is gaining increasing attention. It has also triggered questions whether the usage of this risk-free backstop for money might be a sign of systemic stress or cause other potential problems down the road. Below, we provide our take on recent developments on the USD money market and their potential implications for the Fed and markets.
Downside pressure in short money market rates. Federal funds are reserve balances that banks deposit at the Fed. The effective fed funds rate – the weighted-average overnight interest rate institutions charge each other for unsecured overnight loans of funds – has declined to 0.06% and was temporarily down at 0.05%, not far from the lower bound of the Fed’s target range of 0.00 0.25%. The underlying reason for the downside pressure in money market rates is that the market is awash with cash due to an oversupply of reserve balances. The Fed uses the interest on reserve balances (IORB, currently 0.10%) and the reverse repo rate (RRP, currently 0.00%) to steer the effective fed funds rate. Under normal circumstances, the effective fed funds rate tends to trade slightly below the IORB rate as all institutions involved are not eligible for the IORB rate at the Fed. The RRP rate – the offering yield on the Fed’s overnight reverse repurchase agreements – acts as a floor for the effective fed funds rate. As a result of mounting excess reserves in the banking system, other money market rates have approached the RRP rate and overnight GC government repos have been occasionally trading at sub-zero levels, as illustrated in the following chart.
USD short rates: ON GC government repo trading partly below zero
Not all participants are eligible for IORB. Depository institutions (DI) and other eligible entities (for example US branches and agencies of foreign banks) receive interest at the IORB rate (currently 0.10%) on their reserves at the Fed. Some institutions that are eligible to lend funds in the fed funds market are not eligible to earn IORB, most notably the government-sponsored enterprises (GSEs). Nowadays, GSEs are primary sellers of fed funds to DIs, who borrow funds slightly below the IORB and then deposit the funds in their reserve account at the Fed, earning the IORB and pocketing the difference between the IORB and the effective fed funds rate. Only a small part of fed funds trades occurs between DIs, reflecting their cash management and funding needs.
More expensive for DIs to hold reserves due to SLR rule. The recent change to the Fed’s supplementary leverage ratio (SLR) has made it more expensive for DIs to hold reserves at the Fed after the end of the temporary exemption of reserve balances from SLR calculation at end-March 2021. The SLR rule limits the size of bank balance sheets relative to Tier 1 capital. While the removal of the SLR exemption did not cause much drama in the markets, it has potential implications, especially on large DIs’ willingness to hold reserve balances, for example, by turning away depositors in order to limit the balance sheet growth at a time when the Fed’s bond purchases and the decline in the Treasury General Account (TGA) add to the bank reserves.
According to the Fed’s Senior Financial Officer Survey released last week, one third of respondents said that they are already taking action to limit the size of their balance sheets and expect to continue to do so, with another third saying that they would seek to maintain or reduce the balance sheet size instead of growing it.
Around half of the respondents, accounting for around 75% of the all reserve balances of the banking system, cited the pressure on net interest margin and return on assets as factors for restricting the balance sheet. It is worth noticing that the survey was conducted in March, prior to the change to the SLR rule.
More costly reserve balances push funds to reverse repos. An important channel for the bank reserves that are not deposited by DIs at the Fed is money market funds that can use the Fed’s reverse repo facility (but are not eligible to IORB at the Fed). After being idle for almost a year, the usage of the RRP overnight facility has skyrocketed since early-April, with the daily volume increasing from negligible to near USD 500bn, and the number of participation institutions has increased sharply. The Fed increased the daily counterparty limit of the RRP facility from USD 30bn to USD 80bn in March, facilitating the usage of the RRP, probably also in anticipation that the change to the SLR rule would make DIs more hesitant in mounting deposits, resulting in more cash to be channelled to the RRP facility.
Reverse repo (RRP) facility volume
At the same time, reserve balances deposited at the Fed have continued to decline, which may partly be a reflection of DIs aiming to limit the increase in deposits, as suggested by the Fed survey.
Reserve balances with federal reserve banks
Several factors contributing to increasing reserve balances. The Fed continues to buy assets for USD 120bn per month and that money has to go somewhere. At the same time, the Treasury has been spending its elevated deposits at the Fed (Treasury General Account, TGA), which directly ends up in the banking systems and adds to the reserve balances. The negative net issuance of T-bills has squeezed instruments available for purchases at the short end of the curve. The Fed’s asset purchases have also contributed to the lack of collateral in the repo market, which has depressed the GC government repo rate (see the picture on USD short rates above) and increasingly forced market participants to seek other investment alternatives.
With returns on money market investment alternatives near zero (or even negative), an increasing share of the cash pile ends up parked at the Fed’s reverse repo facility instead.
Treasury cash balance (TGA) and T-bill issuance
Money market funds a key player. Money market funds play an important role in the US short rates market as they drain excess reserves from the system. Some concerns have been voiced regarding money market funds’ willingness to continue absorbing reserves that DIs with access to IORB do not want. Part of these funds are channeled to money market funds instead, where, to a larger extent, they end up at a zero rate at the RRP as other investment alternatives have become increasingly limited and unattractive due to their low (or negative) returns. With money market funds facing zero return on an increasing part of their investment, they risk being forced to offer zero or negative returns to their investors over time. A substantial decline in money market funds’ AUM could potentially jeopardise the availability of credit to corporates in the commercial paper market. The Fed has also previously noted that a large RRP facility could potentially contribute to financial stability risks by directing money from corporate commercial paper to RRP facility during times of flight to quality.
Continued increase in the RRP facility expected. As long as the Fed continues to provide increasing bank reserves, more cash has to find a home somewhere. This is likely to contribute to a further substantial increase in the usage of the RRP facility. Also, the volume of the RRP facility tends to see quarter-end spikes as foreign banks, which are important borrowers on the fed funds market, reduce their borrowing activity in order to limit their balance sheets. This result in GSEs, which are important lenders of federal funds, depositing funds at the RRP facility instead.
Fed sees a need to address near zero money market rates. In the minutes of the 27 28 FOMC meeting, Lorie K. Logan, the System Open Market Account (SOMA) manager, acknowledged the strong demand for safe short-term investments and reduced T-bill supply and the fact that a “modest” amount of overnight repo markets occurred at negative rates. Ms Logan noted that downward pressure on overnight rates in the coming months could result in conditions that warrant consideration of a modest adjustment to administered rates (RRP and IORB) and could ultimately lead to a greater share of the Fed balance sheet expansion being channelled into RRP facility and other Federal Reserve liabilities. Ms Logan also said that the Fed’s open market desk is planning to expand counterparty eligibility on the reverse repo facility in order to make it accessible to smaller money funds and GSEs, in order to strengthen the effectiveness of monetary policy implementation tools.
Fed likely to raise administrative rates in June. For the reasons discussed above, it is likely that the Fed will soon increase the IORB and the ON RRP rate slightly 5bps), probably at the June meeting. It is also possible that the Fed will implement some of the measures discussed at the minutes of the April meeting in order to broaden the eligibility criteria for the RRP facility with the aim of easing the downside pressure of short rates.
A positive ON RRP rate would help to ease the pressure on money market funds and thus contribute to guaranteeing the functioning of the Fed’s system of steering short rates. A minor adjustment to the Fed’s administrative rates would be seen as technical and, as such, should only have minor effects on longer rates and the dollar.
Swedish krona: Change in AP7 Investment Guidelines could have material flow implications for SEK
AP7 is the state alternative to the private investment funds offered within the Swedish premium pension system (PPM). There is currently a Government Committee of Inquiry on including AP7 into the same investment guidelines as the other buffer funds AP1, AP2, AP3 and AP4 which could mean that the fund will have to start FX-hedging their foreign assets. If decided this would likely take years to implement but it would have a significant flow effect on the SEK most likely offsetting the current Riksbank selling of SEK 5bn/month (done by Riksbank in order to build their FX Reserves).
Yesterday we briefly spoke to the Ministry of Finance. Obviously, they are not going to give us any details on the conclusions in the upcoming Governmental Inquiry and what the final proposal will look like as regards the future investment mandate of AP7. However, we did learn that the timing for when the parliament will have the final bill on their table will be delayed as the bill will not be included in the collection of proposals expected to reach the Riksdag (Swedish parliament) before summer. Instead, the first likely opportunity to be included is after the summer, sometime in early September when the Swedish parliament is reopening after summer holidays. Hence should AP7 have to start to hedge some of its foreign assets this process will commence at the earliest in 2022.
As regards the short-term outlook for SEK we think the current positive cycle of strong risk appetite and cyclical recovery should play well for the krona and we are surprised that we have not yet tested 10.00 in EUR/SEK yet. We recommend selling EUR/SEK on rallies to 10.20, targeting a move below 10.00 (and stop above 10.30). The clear risks for SEK are focused around Fed tapering and fading risk appetite with the USD still being a clear defensive currency.
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
Open trade recommendations
Closed trade recommendations in 2020
Systematic currency strategies
Jussi Hiljanen jussi.hiljanen@seb.fi
46850623167
Daniel Bergvall daniel.bergvall@seb.se
Carl Hammer carl.hammer@seb.se
46703026128
Claus Hvidegaard claus.hvidegaard@seb.dk
45 24 60 39 23 Elisabet Kopelman
elisabet.kopelman@seb.se
Marcus Widén marcus.widen@seb.se
46706391057
