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Despite our expectations that EURSEK would retrace lower this month to stabilise around 11.4, the cross has actually rallied through April, rising around 1.5% to trade at 11.7 at the time of writing.
Even so, we still think our broad underlying thesis for the pair remains intact. This is because the key driver for the move higher this month came from escalating tensions in the Middle East, which led to a broad risk-off move across FX markets, with this dynamic weighing notably on high beta currencies such as the krona. While this illustrates the sensitivity of EURSEK to geopolitical developments, highlighting that upside risks to the cross remain, we are inclined to view April’s moves as idiosyncratic, particularly in light of recent de-escalation between Iran and Israel.
Instead, we expect monetary policy to return as the main driver of the cross in the coming months, with this set to see EURSEK return to the 11.4 level under our base case.
In terms of monetary policy, divergence, or lack thereof, remains the major theme. In the eurozone we are expecting the ECB to ease rates four times this year, with the first cut all but guaranteed to occur in June based on recent ECB commentary. This view is broadly shared by markets as well, with traders currently ascribing a 90% chance to the prospect of a cut in June, with a total of three rate cuts priced for the whole of 2024 at present. In contrast, we expect the Riksbank to deliver four rate cuts at most, with the balance of risks skewed towards slower easing from Swedish policymakers. If we are right, then rate differentials should widen marginally in favour of SEK over the coming months. Markets, however, are yet to fully align with this view. The swap market is currently pricing the Riksbank’s May 8th rate announcement as close to a coin toss, with a June cut in Sweden more than fully priced.
Similar to mid-2023, EURSEK uncoupled from rate expectations in April due to idiosyncratic factors. With these now fading, rate differentials should return as a main driver for the cross, suggesting a retracement lower is likely
Taken at face value, recent data has made a case that policymakers should be seriously consider a rate cut in May.
Growth indicators suggest that economy contracted in Q1, while unemployment figures jumped in March to 8.6%, up from 8.1% in February. Even so, there is good reason for policymakers at the Riksbank to discount these outturns. Despite the disappointing start to the year, growth figures are broadly in line with Riksbank forecasts. Meanwhile, labour market readings are typically volatile. In fact, the jump in the unemployment rate was driven by a significant rise in the labour force, with the participation ratio increasing from 75.2% to 75.6%, not an increase in overall layoffs as the employment rate remains at the Riskbank’s target of 69%.
The one development that does weigh in favour rate cuts is the disinflation progress. CPIF inflation printed at 2.2% YoY in March, down from 2.5% in February, well below the Riksbank’s forecast for CPIF to rise to 2.7%.
CPIF ex-energy also undershot expectations, falling to 2.9% YoY, delivering a similarly notable undershoot of the 3.3% predicted by Bank staff. All told, this could offer sufficient cover for policymakers to cut rates next month. Even here though, we think there is reason for policymakers to be cautious, especially given that recent krona weakness points to imported inflation tracking above Riksbank expectations over the next few CPI releases.
A hold in rates still looks the most likely outcome in May given the recent SEK sell-off
On balance, we think the Riksbank will hold rates in May for two reasons. First, recent developments in the Middle East should have highlighted that the economy remains vulnerable to inflationary supply shocks, particularly from energy prices, warranting a degree of caution when starting to cut rates. Second, policymakers have placed significant emphasis on currency strength as a requirement for easing policy. Indeed, the March MPR forecasts that saw a 50% chance of cutting rates in May were predicated on the krona strengthening. Since then, SEK has weakened. Whilst not likely to see an immediate impact on price growth, a weaker currency will see higher imported inflation over coming months. Moreover, cutting ahead of the ECB would likely see a sharp EURSEK rally, further exacerbating this problem.
Both factors suggest that upside inflation risks remain, which should weigh against the Riksbank easing policy next week.
If we are correct, and the Riksbank holds rates, then the EURSEK rate should continue to retrace back towards the 11.4 level. If, however, Swedish policymakers decide to ease policy earlier than we expect, then EURSEK returning to test the 12.0 handle isn’t out of the question. Longer term, we remain constructive on the krona against the euro as we expect that policy easing by both the Riksbank and ECB should stimulate demand through the second half of the year. As such we continue to expect a continued retracement lower for EURSEK through the second half of 2024, targeting a EURSEK rate of 10.9 by year end.
Author:
Nick Rees, FX Market Analyst