Today, the Swedish Riksbank raised its policy rate by 25bps, its first hike in over seven years, bringing its policy rate to -0.25%. In doing so, it became the fifth central bank in the developed world to start normalizing its policy rate in recent years, following previous hikes by the Federal Reserve, Bank of England, Bank of Canada, and neighboring Norges Bank.
In many respects, the rate hike is long overdue. Sweden’s real (inflation-adjusted) policy rate is the lowest in the developed world. Inflation, as measured by CPIF (CPI with a fixed interest rate), the Riksbank’s official target variable, has remained above the 2% target since the summer. Long-term inflation expectations have stabilized at around the target since the start of the year. The labor market is tight, with the unemployment rate not far from its pre-crisis trough. And the exchange rate is weak, about one standard deviation from its long-term average, according to our estimates.
But there are reasons to think this hiking cycle will be exceptionally slow, and potentially short-lived.
- As a small open economy, the Swedish economy depends heavily on trade with the rest of Europe. Further tightening ahead of the ECB, which we expect to deliver its first hike late next year, may therefore prove difficult for the Riksbank, at least without strengthening its currency and cooling economic activity too much. A good case in point is 2010, when the Riksbank embarked on a year-long hiking cycle ahead of the ECB. The Swedish krona strengthened versus the euro as a result, external competitiveness dropped, inflation fell, and the Riksbank subsequently reversed all its rate hikes, eventually cutting its policy rate to negative territory in 2015. More generally, going forward, we expect both the Riksbank and ECB to have a difficult time delivering rate hikes at a time when the Federal Reserve is already priced to cut again from 2020.
- Growth and inflation momentum is falling. Swedish growth is “Synching Lower”, along with the rest of Europe. The two most recent inflation reports for October and November were weak. GDP growth was negative in the third quarter. Growth in credit, too, has surprised to the downside in recent months. Worse, global trade volumes have fallen meaningfully since the summer, presenting significant challenges for an externally-driven country like Sweden, where exports account for close to half of its GDP.
- Sweden has one of the most indebted private sectors in the world, with household debt at 180% of disposable income (2017), the bulk of which is in variable rate loans. Even small interest rate hikes may therefore have large dampening effects on the economy, as households are forced to put aside more for savings than consumption. More broadly, the argument that high leverage anchors interest rates lower is a global theme, as we have explained in our New Neutral thesis.
Despite low absolute yields, we think Swedish interest rates offer solid return potential. The yield curve is steep, which allows for attractive carry as the investment “rolls down” (with an upward sloping yield curve, a bond is valued at successively lower yields and higher prices as it approaches maturity). Based on the above, we also think the Riksbank is unlikely to hike rates faster than what is discounted in forward prices (about one hike per year going forward). Meanwhile, we remain cautious on the Swedish krona. While long-term fundamentals (e.g. strong current account, productivity differential) point to the currency strengthening over time, fading growth momentum and slowing external demand present short-term risks.
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