The persistent rally in EURSEK over recent weeks has not come as a surprise to us given the sustained deterioration in the market’s risk appetite and our view that rates traders were under-pricing the ECB’s terminal rate.
If anything, although we did expect these developments, they have taken place even faster than we anticipated, with the recent moves bringing EURSEK almost exactly in line with our three-month target of 11.50. Today’s breach of the cross’s previous peak has been driven by the markets focus on sticky inflation, especially given yesterday’s eurozone PMIs which showed momentum remained high in core services inflation and today’s hotter-than-expected UK inflation report. With financial stability concerns still prominent and a recession in Sweden doing the Riksbank’s dirty work, signs of inflation persistence in Europe are likely to only widen the spread between European and Sweden interest rates, especially in real terms. All else withstanding, this should maintain upwards momentum in EURSEK.
Rate expectations have increased further for the ECB than the Riksbank in recent weeks, driving EURSEK higher
So, what next for the Riksbank?
In our view, the most likely outcome for the Riksbank is one more hike and done at this point. The recent shift in the tone of communications suggests to us that the Riksbank has now conceded defeat in attempting to talk up the krona, and that the hiking cycle is likely to be concluded in June. While this poses risks of further SEK depreciation and thus another inflationary impulse, domestic inflation pressures are cooling and financial stability risks remain elevated, meaning the balance of risks are too high for an extension in the hiking cycle from here. We would also note that in terms of FX passthrough to inflation, the rate of change is the key factor. With the cross only recently breaking out of its YTD range, the impact on imported inflation is likely to be limited and the Riksbank has confirmed as much recently. Therefore, having given up on trying to support the krona through hawkish rhetoric, and whilst continuing to publicly express a preference for a stronger currency, it does not appear likely the Riksbank will attempt to counter modest SEK weakening in the short run. It also seems improbable that they would intervene in FX markets to support the krona too, despite some previous speculation to this end. Based upon the central bank’s current level of FX reserves and estimates of daily SEK turnover, our rudimentary estimates suggest that the Riksbank could only cover two full days of SEK outflows in the case that the market wholeheartedly tests their resolve.
While swap lines with the ECB and Fed could be tapped to beef up their firepower, this is an unconventional use of their purpose and is therefore unlikely. This means that any attempt to intervene in FX markets to prop up the value of the krona will be seen as unsustainable by traders.
Accordingly, if the Riksbank were going to attempt to support SEK through FX interventions, we would expect them to do it when the depreciation pressures have largely faded, which right now looks some way off.
Modest FX reserves weigh on the Riksbank’s ability to intervene in FX markets
Limited options suggest that modest SEK downside is likely
Given the narrow range of options available to the Riksbank moving forward, the path for EURSEK will mostly be driven by developments elsewhere. In particular, it will depend on how far the ECB needs to go with monetary tightening in the eurozone, and if they are they willing to take rates to or even above 4%. If they do so, it would open up rate differentials even further in a move that the Riksbank would be ill-equipped to match.
But the risk backdrop will also play a factor, especially with worries about the Swedish housing market continuing to rumble on in the background.
Either way, the balance of risks appears skewed toward further SEK depreciation in the short-term, especially as debt ceiling concerns and the impact that could have on US growth rumble on. Although not our base case, a move further towards 12 in EURSEK would represent only a 4.35% depreciation for the krona from current levels. While the pace of depreciation would match the size of the EURSEK trading range year-to-date, such levels could be in range if a series of downside risks begin to materialise for the krona. Ahead of this, the currency cross has a series of resistance levels carved out during the peak of the Global Financial crisis to breach, the most notable of which being its 2009 high of 11.7896.
Nick Rees, FX Market Analyst