Macro & FICC Research Published: 2021 03 19 06 58
SEB FI & FX Strategy
Stairway to heaven – Treasury yield to 2.0%
In market focus. Recovery; Central banks; Inflation; Long rates; Risk appetite.
Global macro and risk appetite. Strong US recovery outlook with more upward revisions to growth forecast expected. Still sufficiently low real yields and positive growth momentum will support stock markets but potentially erratic moves in long rates is likely to cause stock market volatility and test the risk sentiment.
FX: Overvalued dollar. According to our model framework the US dollar remains overvalued. In the coming weeks we will either have a weaker USD or yields will have to continue to rise to correct the misvaluation.
Our models also promote buying higher yielding currencies vs. SEK, JPY and CHF, however there are also some quite strong reasons to expect USD/JPY to head lower in the near-term. Finally, we think seasonality will continue to favour NOK/SEK in the coming 1 2 months.
USD rates: 10y Treasury yield to hit 2.0%. The Fed made no changes to either policy or its guidance on Wednesday and seems relaxed with the recent rise in rates. The strengthening macro outlook increases risks of an early tapering. Markets have somewhat reduced prospects for an early rate hike and rising inflation expectations are lifting long rates. We now expect the 10y Treasury yield to hit 2.00% this year. A possible overshooting in the short term would open for a downward correction later in the year. A decision on the SLR rule will be announced in the coming days with a potential to trigger instant market moves.
EUR rates: ECB not concerned about rising long rates for now. The ECB’s meeting last week was a non- event and subsequent comments by Mr Lane and Ms Schnabel suggest that the ECB is not concerned about higher German long yields in so far as accommodative financial conditions are not threatened. We expect long EUR rates to rise moderately in the coming months, revise our end 2021 Bund target to 0.10% and stick to our bear steepeners.
DKK rates: Duration and liquidity stress has pushed bonds cheaper. The Danish market has been under stress in February and March, which has led to central bank action. Danish government bond yields are at or close to 5-year highs vs. EUR peers and EUR/DKK is pushing through February’s intervention levels, increasing the need for intervention.
Covid 19: Early reopening in the US, mounting challenges in Europe. The decline in US cases has continued which, together with the rapid pace of vaccinations, paves the way for an early reopening. In Europe, most EU countries have temporarily halted the use the AstraZeneca jab, adding to the short supply of vaccines. New strains remain a risk with the limited data suggesting lower vaccine efficacy especially against the South African strain and fatalities in some EU countries have turned higher again.
Forecasts. We revise our target for long rates higher, especially for USD but to a lesser extent for SEK and NOK rates. Find comprehensive forecasts here.
Trade highlights (new targets):
- EUR 2y2y 2y15y steepner 21 Jan). Entered: 54.4bps; Now: 82.2bps; New target: 90bps.
- USD 1y10y vs. EUR 1y10y widener 13 Nov). Entered: 117.7bps; Now: 171.5; New target: 190bps.
- USD 6m2y 6m10y steepener 30 Oct). Entered: 64.4bps; Now: 146.0bps; New target: 155bps; New stop: 140bps.
Fed comfortable with rising yields, paving the way for 10y Treasury hitting 2.0%
The last two weeks have been dominated by key central bank meetings, most notably the ECB on 11 March and the Fed on Wednesday this week, where both kept policy unchanged, in line with expectations. The most relevant message for markets was that both banks have accepted the recent increase in bond yields and are likely to let long yields rise further, as long as the increase is driven by improving recovery prospects and rising inflation expectation (rather than too much higher real yields), and accommodative financial conditions are not threatened. Declining prospects of central banks’ bond market interference any time soon is highly relevant for markets as it allows for further upside in long yields, assuming that the recovery proceeds in line with expectations.
In the previous edition of SEB FI & FX Strategy, 5 March, we stated that the risks to our end 2021 forecast for the 10y Treasury yield of 1.70% are on the upside, and that while a 2.00% yield this year is not our main scenario, it still falls within the realms of possible outcomes. The recent communication by central banks renders it more likely that the 10y Treasury yield will hit the 2.00% level this year, possibly testing such levels already in the coming months, as long as severe bouts of stock market turbulence can be avoided. As discussed previously, a 2.00% level in the 10y nominal Treasury yield would most likely imply that the corresponding US TIPS real yield would increase to the 0.30% / 0.40% area from just over 0.60%
currently. If yields rise too fast relative to the economic outlook, the risk of a stock market correction increases which in turn would trigger safe-haven buying in Treasuries. Our main scenario is that the risk appetite could probably tolerate a real yield of 0.30% / 0.40% later this year, given the improving growth prospects but that such levels near-term could test both the risk appetite and the Fed’s patience, especially if it was to happen before the recovery becomes evident also in hard data for especially the labour market.
Thus, the ride is likely to be bumpy as short-term movements in yields may be larger than the risk sentiment tolerates, in such cases triggering temporary setbacks in equities and long yields.
We revise our end 2021 target for the 10y nominal Treasury yield from 1.70% to 2.00%. Admittedly, the time axis of the forecast has a lot of uncertainty as markets could see the yield temporarily overshooting to 2.00% already before the summer, only to return back as a result of eventual negative effects on the risk sentiment. Our main message is still clear: We see a continued upside in US long rates in the coming months, the Treasury yield expected to hit 2.00% at least temporarily in likely volatile markets.
SEB Equity Strategy: Value rotation - fast or slow?
As regards stock markets, our colleagues at Thomas Thygesen's SEB Equity Strategy team say that the main issue is what multiple markets will pay for the higher earnings. If a too rapid rise in long real yields can be avoided and other major central banks continue to provide more stimulus, then the near-term result will be more balanced when it comes to the performance of growth versus value, but the stock market as a whole will have more upside. This is the more likely outcome but higher yields over the strategic time horizon implies that the trend is towards value outperforming over time, but as always value investments will require patience.
FOMC: Strong recovery outlook and data dependent Fed shifts risks towards earlier tapering The Fed, as expected, made no changes to either policy or its guidance on Wednesday. FOMC members are optimistic on the economic outlook and more split over the outlook for rates, but the median forecast continues to signal unchanged policy rates until at least the end of 2023. The message from Chair Powell was that data will decide and that the Fed will not move preemptively. Thus, the Fed is keeping the door open for acting both earlier and later than suggested by the “dot plots”. As we expected, more FOMC members are now leaning towards a faster lift-off, however. 7 out of 18 members now see at least one rate hike before the end of 2023, and four now seeing it happening as soon as next year. In comparison, in December, five members saw a rate hike by 2023 and only one in 2022. The dots also moved higher signaling a faster pace of hikes.
In line with our expectations, FOMC members are seeing very strong growth for the current year 6.5% y/y in Q4) and gradually moderating thereafter, unemployment back at the lows prior to the pandemic at 3.5% at the end of 2023 but PCE inflation only slightly above target 2.1%) by the end of the forecast period. Also worth noting is that FOMC members in their forecasts now say that PCE inflation at 2.4% by the end of this year and core PCE at 2.2% would not be a reason to change course since that could be deemed transitory and FOMC members expect inflation to decline again thereafter.
With regard to tapering, Mr Powell repeated that the Fed will signal well in advance when it believes it is getting closer to the point where it may start reducing asset purchases but that now is not the time. Similar to the case for rates, the decision on tapering will be based on actual outcomes, not forecasts.
On yields, Mr Powell delivered the same message as on previous occasions. The Fed does not want to see disorderly market conditions or a persistent tightening of financial conditions. The current stance is, according to the Fed, appropriate. Thus, in line with expectations, Mr Powell did not signal any changes in its asset purchases. We continue to expect tapering in 2022 but risks of an earlier tapering are increasing.
Finally, Mr Powell did not want to comment on the question of whether the Fed will prolong the current exemption of the SLR (Supplementary Leverage Ratio) for bank holding companies’ holdings of US Treasuries and bank reserves but said that a decision will be announced in the coming days. There were no changes to the Fed’s IORB or RRP rates but as discussed previously, a technical upwards adjustment is expected during the spring (more about the FOMC meeting here).
With regard to market expectations of the Fed lift-off, fed funds futures are now discounting an around 50%
probability for at 25bps rate hike by end 2022, up from around 15% in early January but down from 80% in late February.
Fed funds Jan23 implied rate
If anything, the recent decline in policy rate expectations for 2022 indicate that markets are at least slightly more confident that the Fed will wait until 2023 before hiking rates, despite the more positive outlook for growth and inflation. This is also reflected in market inflation expectations that have seen a revival after being downbeat in the second half of February when the rise in nominal yields was only due to rising real yields.
US 10y real yield and inflation expectations (BEI)
EUR rates: ECB not concerned about rising long rates – Stick to strategic bear steepeners
With the Fed policy fully data dependent and consensus expectations for growth set to be revised higher in the coming months and inflation rising, there is not much to suggest anything other than a continued upside trend in the long US yields. Long euro rates in turn have become increasingly affected by the US and
international yields since mid-January and given the ECB message, it is unlikely that the recent pattern will be broken anytime soon.
10y nominal yields
Expectations for the ECB’s 11 March meeting were muted, and the meeting indeed resulted in policy as unchanged as it can be. In the press release the main change compared to the January meeting was that asset purchases over the next quarter will be ‘’conducted at a significantly higher pace than during the first months of this year’’. This was widely expected considering the recent upside pressure on yields and slightly lower volume of purchases over the past few weeks. The ECB also reiterated the earlier message that the PEPP can be used in full, less than allocated, or more. The overall message from the ECB is that it is taking a holistic view on the economic development and financing conditions, and that it wants to retain flexibility in implementation (more here).
The GDP forecast was revised up 0.1pp in 2021 to 4.0% and down by a similar amount to 4.1% next year and left unchanged at 2.1% for 2023. The inflation forecast for 2021 was revised up from 1% to 1.5%
largely due to higher energy prices, but also the reversal of the temporary VAT reduction in Germany. The inflation forecast for 2022 1.2%) and 2023 1.4%) was largely unchanged.
In an interview with the FT 16 March), the ECB’s Chief Economist Philip Lane stated that the ECB’s “objective is basically to make sure that yield curves do not move ahead of the economy” and that “over time the relation between the appropriate level of yields and inflation will move”. In an interview with Les Echos, ECB Executive Board member Sabine Schnabel said that “recent changes in risk-free rates have been consistent with an improving growth outlook. Rising inflation expectations have been a key factor driving yields higher, signalling that the policy measures in place are bearing fruit. What concerns us is not so much the level of interest rates – which are still very close to their historic lows – but rather the rapid change. But it would be wrong to think of us as having defined a threshold above which we have to respond”. We read Mr Lane’s and especially Ms Schnabel’s comments as having a slight hawkish bias as they downplay the increase in yields as long as the rise is driven by an improving economic outlook and rising inflation expectations.
German 10y real yield and inflation expectations (BEI)
As we have stated earlier, we don’t find the PEPP in its current form a credible tool for curbing an overall rise in yields. While some earlier ECB comments, for example by Fabio Panetta, suggest that the board is divided on the issue of rising yields, it seems that for now the ECB GC is following the Fed by taking a relaxed stance on higher bond yields, as long as spreads within the euro area does not widen significantly. For the coming few months, it appears unlikely that the ECB would actively seek to curb eventual upside pressure in German long yields as long as the rise in yields is driven by improving economic prospects and rising inflation expectations. Following the upward revision of our Treasury yield forecasts, we now target the German 10y yield at 0.10% in end 2021, up from 0.20% previously.
In January, we recommended strategic steepeners on the EUR curve (Time for the EUR curve to start catching up, 22 January) and we stick to our existing EUR 2y2y 2y15y steepener. While most of the steepening has been beyond the 5y point of the EUR curve, even the short end has steepened somewhat. We foresee a continued bear steepening of the curve over the coming months and would regard dips in long rates as an opportunity to establish new bearish positions.
Overvalued USD
EUR/USD is trading with a large USD overvaluation according to our short-term fair value model. The misvaluation decreased somewhat following the FOMC on Wednesday but nothing major changed as the Fed does not voice concerns about higher US yields. A trigger for a larger correction higher in EUR/USD and lower in USD in general would be if the Fed changed its communication, which we do not expect at the moment.
EUR/USD versus its short-term fair value
Source: SEB
We have developed a model assessing the short-term fair value for the DXY dollar index to be able to discuss USD valuation in a broader sense than versus individual G10 currencies. This model also indicates the USD to be overvalued, but slightly less so following the FOMC meeting. The models reveal, not surprisingly, that the rate spread is once again a key driver for the USD while global risk appetite is a bit less of a driver than it was earlier this year and late last year. Also of interest is the shrinking volatility-based confidence bands used for assessing the normalized misvaluation (i.e. measured in standard deviations). With really tight confidence bands, even a rather small spread in terms of spot minus fair value provides a large normalized deviation.
However, the recent misvaluations (which peaked on 8 March) have also in pure spread terms been historically quite large. Finally, such tight confidence bands, just as for tight bands in a traditional Bollinger band analysis, is the harbinger of a coming larger change.
DXY US dollar index versus its short-term fair value
Source: SEB
Even though the DXY USD index has thrived in the current US yield driven market, one should have a bit broader perspective if looking to enter a trade that would benefit from a continuation of this environment.
The DXY index mostly comprises low yielding currencies versus the USD and when instead looking at equally weighted G10 indices it is clear that there are other high yielding currencies that have performed even better than the USD in this environment (see chart below). In this perspective it would make more sense to go long a basket with CAD, NOK and the USD versus a short basket of low yielding CHF, JPY and SEK. The notion of long NOK vs. short SEK, which has support from other trading strategies as well, are discussed more fully below.
But a long USD/JPY carries several risks: 1) USD/JPY tends to head lower at the end of March due to repatriation flows heading into the end of the Japanese fiscal year, 2) positioning is severely stretched and thus extra sensitive if the price starts to fall, and 3) USD is largely overvalued vs the JPY according to our short-term fair value. These three factors have, however, been in play for over a week without a major correction lower in USD/JPY. On the other hand, its previous relentless rise (most of 2021) has paused which could be the first step before the correction lower sets in.
Performance since the US yields began rising indicates a basket where one is long the higher yielding currencies CAD, NOK and the USD versus the low yielding CHF, JPY and SEK, if one expects the current market environment to continue.
Source: SEB
Scandie FX: Diverging views
Regarding the Scandies, the Norges Bank’s rate decision yesterday delivered a hawkish message moving the rate path suggesting a rate hike as soon as Q4 2021 compared with Q1 2022 from the December 2020 meeting (more here). However, much of this was already anticipated leading to quite small market reactions especially in EUR/NOK. NOK/SEK, on the other hand, gained for a second straight day and long NOK/SEK at the moment makes sense based on many different trading approaches: 1) it is a clear central bank divergence trade with a hawkish Norges Bank and a dovish Riksbank, 2) it has some carry, 3) seasonality favors it as the SEK is about to enter the Swedish dividend period during which it tends to weaken, and 4) finally NOK is among the “high yielding” currencies which have been supported during the current yield focused market and should continue to thrive as long as the Fed does not derail and begin voicing concern about the high US yields (see chart above).
Swedish dividend payments during the spring tends to be a headwind for the SEK around the third week of March until the third week of May. Excluding 2020 when there were no dividends due to the pandemic situation, EUR/SEK has on average risen by 2.2% during this time. Two other factors explain some of this rise, a general uptrend in EUR/SEK 7 out of the past 10 years and a tendency for the Riksbank to be dovish in its April rate decisions. However, neither of them can explain the large 2.2% average rise. We expect a
somewhat smaller reaction this year but still expect EUR/SEK to rise above its 10.20 resistance level, which it has not broken above so far in 2021, and trade in a new range between 10.15 and 10.35.
DKK rates: Duration and liquidity stress has pushed bonds cheaper
The 22bps increase in the 10y EUR swap during February caused a significant extension in the duration of the Danish callable market adding 60% to the original duration averaging 4 on the approx. DKK 1,300bn market. As we have seen on previous occasions when rapid interest rate moves have pushed duration to peak levels, this has led to a DKK duration-congestion and thus a widening pressure on Danish rates.
Average duration in the callable bond market & 10y government spread between Denmark and Germany
Source: SEB
In an unfortunate turn of events , the timing of the interest rate move coincides with the Danish liquidity surplus moving towards its annual seasonal low at the end of March, which this year is projected to be the lowest level of liquidity surplus in more than 10 years.
DKK liquidity surplus including forecast based on official numbers through April
Source: SEB
Since Nationalbanken intervened against DKK weakening vs. EUR a year ago and hiked rates 15bps vs. ECB, the liquidity surplus has been at a lower level, putting further upside pressure on Danish short rates. The forecasted and realized liquidity drain in Q1 this year has exacerbated this effect in the EURDKK FX forward market, which has increased the cost of hedging DKK bonds, and pushed the gradually appreciating Danish krone towards a level that finally led Nationalbanken to make small scale interventions against a strong DKK in February.
DKK/EUR interest rate spread in the money market and FX forward market
Source: SEB
As a response to the liquidity induced increase in Danish short rates, Nationalbanken on Friday last week announced a technical adjustment of its rates as of 19 March, abandoning its tiered deposit setup and moving to a unilateral rate across its current account and certificates of deposit, which is set at 50bps, 50bps below the previous current account rate of 0.0%, but 10bps above its previous CD rate. At the same time it made its extraordinary lending (repo) facility at 0.35% permanent (the previous ordinary repo rate was 0.05%). This succeeded in lowering the EURDKK FX forwards, as illustrated above, but pushed short government cash rates higher to trade at or above the new marginal deposit rate, which is now 50bps as opposed to the previous CD rate of 60bps.
Government spreads vs. Germany and France
Source: SEB
As a result, outright Danish bond yields are at or close to 5-year highs vs EUR bond rates, and EURDKK is pushing through February’s intervention levels, increasing the need for intervention. Even with a XCCY swap the 5y issuance segment for Danish bullet covered bonds have moved from cheap to very cheap, and with a level 1b LCR status seems ripe for the picking for banks LCR portfolios.
5y covered bond ASW-spreads basis-swapped to SEK compared to other covered bond markets
Source: SEB
If Nationalbanken does not succeed in stopping the appreciation pressure on the Danish krone, we expect them to intervene for an amount of DKK 50 70bn, after which next step will be to lower the deposit rate.
Covid 19: US heading for early reopening, new restrictions in Europe
In the US, Covid 19 cases have continued to decline over the past two weeks with fatalities declining even faster, which together with the fast pace of vaccine administration is supporting an early reopening. In the EU, the recent positive developments in case numbers have come to a halt with the more infectious and
potentially more serious UK strain (B.1.1.7) gaining ground in many countries. In some countries, fatalities show signs of turning higher again, for example in Italy where half of 20 regions entered lockdowns earlier this week with the lockdown set to remain in place until 6 April. In Germany, recent forecasts by Munich University suggest that new restrictions and possibly a full lockdown is likely before the Easter based on case limits agreed on 3 March by Chancellor Merkel and the 16 state leaders – the next meeting is scheduled for late March.
Covid 19: Daily change on confirmed cases 7d MA)
Despite positive developments since January, the emergence of new Covid 19 strains that might partially evade vaccines is a risk in even in the US. According to Dr Fauci, director of the National Institute of Allergy and Infectious Diseases, the more transmissible B.1.1.7 strain that was first identified in the UK is expected to become the dominant variant by later this month or April. Other variants that are causing concern are B.1.351, identified first in South Africa, and P.1, originating from Brazil. All three strains as are regarded as more infectious, and potentially capable of resulting in more severe Covid 19 cases and more fatalities. The limited data so far suggests that the vaccine efficacy especially against the B.1.351 may be dramatically lower (read more in MedicalNewsToday).
The pace of vaccination has continued to gain speed in the US, where more than two million daily doses have been administered over the past week. As a larger share of the population is vaccinated, the risks of new strains gaining a foothold is considered lower but not eliminated. President Biden has directed states to widen the eligibility for Covid 19 vaccines to all US adults by 1 May, aiming at allowing small gatherings by 4 July. Following the US approval in late February, the EU approved the Johnson & Johnson single-shot Covid- 19 vaccine last week, but a worsening supply shortfall after problems with the AstraZeneca jab means that the EU continues to face significant headwinds in ramping up the vaccination campaign with herd immunity levels likely to be reached several months after the US. In the US, over 20% of the populations has received at least one jab. The chart below shows vaccine doses administered per 100 people counted as a single dose (not equal the total number of people vaccinated as people receive multiple doses).
Vaccine doses administered per 100 people
In the past fortnight, the majority of European countries, including Germany, France, Italy and Spain, have suspended or are limiting the use of the AstraZeneca Covid 19 vaccine following reports of the vaccine possibly contributing to blood clots. Another cut to the delivery forecast for the AstraZeneca vaccine and the decision to suspend its use in many countries is adding to the tensions between the EU member countries on how the available jabs from other vaccine producers should be distributed within the bloc considering that some countries had originally opted for a larger share of the AstraZeneca jab due to its lower price. While the European Medicines Agency (EMA), most recently yesterday, and the WHO say that so far there was no signs the problems had been caused by the jab, negative publicity may contribute to public hesitance concerning Covid 19 vaccines, which has been quite high in some countries even before the recent incidents.
Vaccine doses administered per 100 people
As regards financial market implications, Covid 19 constitutes a tail-risk for the markets. While recent developments contribute to expectations that reaching herd immunity in the EU will be delayed until the autumn, positive developments in the US are more important for the markets. It would most likely need expectations for the efficacy of vaccines to suffer a major blow, rather than a delay in the vaccine roll-out, to derail financial markets.
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
Note: Due to technical issues, open and closed trade recommendations, and summary tables are left out from this edition.
Jussi Hiljanen jussi.hiljanen@seb.fi
46850623167
Claus Hvidegaard claus.hvidegaard@seb.dk
45 24 60 39 23
Elisabet Kopelman elisabet.kopelman@seb.se
Karl Steiner karl.steiner@seb.se
46 70 3323104
