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Riksbank’s extreme dovishness at odds with peers’ shifting tone

The European Central Bank’s shift of tone last week leaves one of its northern neighbours grappling with a dilemma — and investors facing the consequences.

Despite enjoying a robust rate of economic growth in Europe, Sweden has maintained some of the most extreme monetary easing policies on the continent, buying up 40 per cent of the country’s outstanding stock of government debt — totalling SKr275bn — between February 2015 and April 2017, and pledging to extend the programme by an additional SKr15bn in the second half of the year.

Sweden’s official borrowing rate is -0.5 per cent, and forecasts for a rise have been repeatedly pushed back since the start of the year. The Riksbank and most economists now expect the repo rate will remain negative until 2019.

This expansionary monetary policy is driven by the Riksbank’s focus on achieving a 2 per cent is this headline year-over-year inflation rate. The latest readout was 1.7 per cent, although an alternative measure of inflation set to become the official statistic later this year currently reads 1.9 per cent.

Thomas Harr, global head of FICC research at Danske Bank, says the Riksbank was “one of the only central banks trying to live up to their inflation mandate”, but encouraging recent data gave it more freedom as “inflation expectations are now pretty well anchored”.

The bank’s dovishness has suppressed government bond yields and the country’s currency.

The Swedish two-year bond yield entered negative territory in late 2014 in anticipation of quantitative easing and has since dropped as low as -0.741 per cent. The 10-year yield has remained just above zero, dipping as low as 0.042 per cent in mid-2016. Yields fall when prices rise.

The krona fell to six-year lows against the euro in late 2016, passing the milestone level of SKr10 per euro. A series of dovish updates from the central bank has spurred a reverse after a brief rally at the start of this year.

The central bank’s negative interest rates have made the krona attractive for carry traders, who take advantage of cheap krona to fund investments in higher-yielding currencies.

But indications of policy shifts in Norway, Canada, the UK and the Eurozone have left the Riksbank as the only major central bank still stating that further rate cuts are more likely than a rise.

European Central Bank president Mario Draghi’s remarks last week triggered a market sell-off as investors anticipated that the era of ultra-low interest rates and unprecedented central bank bond buying are coming to an end.

Swedish government bonds jumped to a six-week high; the two-year bond climbing to -0.624 per cent, while the 10-year hit 0.662 per cent. The krona had its best week in three months, strengthening 1.1 per cent against the euro.

This puts pressure on Riksbank’s executive board as it prepares to announce its latest interest rate decision on Tuesday.

Robert Bergqvist, chief economist at Swedish bank SEB, says it was “quite obvious” that it was “now more difficult to justify unconventional monetary policy” given “what is happening in the Swedish economy and this new international central bank environment”.

More than two-thirds of investors surveyed by SEB said they expected the Riksbank to remove its easing bias this week. Expectations of the first rate hike have also shifted forwards, with more than half expecting a rise earlier than the Riksbank’s current indications of mid-2018.

Not everyone agrees: analysts at Nordea Markets say that leaving the easing bias in place “is very cheap protection against low inflation”, and predicted the Riksbank would keep its policy in place.

Whatever the Riksbank’s decision, Mr Bergqvist expects bond yields to remain low in the coming months: “There is a short-term imbalance in the bond market because strong government finances mean there has been a decline in the supply of bonds, while the Riksbank is continuing its buying programme for at least the next six months.”

That leaves investors’ attention focused on the krona, which SEB estimates is 10 per cent undervalued.

Higher rates would likely cause the krona to rally. Sweden’s economy is extremely reliant on foreign trade, meaning a stronger currency would reduce import prices and subsequently cause inflation to decline.

Danske Bank’s Mr Harr says the widespread assumption that the easing bias will be removed means any initial strengthening in the krona is likely to be limited, while it could drop sharply if investors are disappointed.

Even if policy does change, he adds, the Riksbank will try to stop a repeat of last week’s sharp moves in the euro and sterling: “People have underestimated how dovish the Riksbank is and how much they’re willing to fight; even if they remove the easing bias they will not turn hawkish.”