Sweden Debt Market Tensions Show ECB What Exit Brings

The European Central Bank need only look north to Sweden to see what may happen when it begins to withdraw liquidity.

Since the Swedish Riksbank became the world’s first central bank to end emergency loans just over a month ago, short-term interest rates have soared to the highest levels since January. The withdrawal of 300 billion kronor ($46 billion) of crisis loans has also sparked a selloff in the country’s mortgage debt market, which is twice the size of its government bond market. The difference between mortgage rates and swaps last month rose to the widest since March, as Sweden’s covered-debt market slumped.

The tensions in Sweden, which boasts the European Union’s smallest budget deficit, come as President Jean-Claude Trichet signals he’s undeterred in withdrawing the emergency measures the ECB introduced to fight the financial crisis. The risk for Trichet is that too speedy an exit will switch off the flow of credit to cash-strapped banks in Ireland, Greece and Portugal, worsening a crisis across the euro region’s periphery.

“The Swedish exit has proved that financial systems still are extremely vulnerable and that confidence is not that great,” said Andreas Halldahl, who helps manage about $15 billion in fixed-income assets at Storebrand Kapitalforvaltning AS in Stockholm. “The implications for Europe could be severe if the ECB doesn’t handle things delicately.”

Unlimited Cash

The ECB’s last set of six-month loans falls due on Nov. 11, while its 12-month lending program ends on Dec. 23. While the ECB is still offering banks unlimited cash at its benchmark rate with seven-day, one-month and three-month maturities, Trichet said on Nov. 4 the ECB will decide on the next steps next month.

Europe still needs ECB liquidity support, said Joakim Buddgard, a fund manager at Svenska Handelsbanken AB in Stockholm, who helps manage $13.5 billion in fixed-income investments. “Otherwise some of the euro countries with debt problems will be in even more trouble.”

In Sweden, the withdrawal of crisis funds made the biggest dent on covered bonds, which are backed by cash flows derived from mortgage debt. The asset class shares the top credit rating with Sweden’s government debt.

The Riksbank’s liquidity program had encouraged a so-called carry trade, whereby banks had borrowed cheaply at the central bank’s rate and used the funds to purchase higher-yielding mortgage-backed assets. The Riksbank left its benchmark rate at a record-low 0.25 percent until July this year. The covered bonds were then used as collateral for new central bank loans.

Carry Trade

When the Riksbank exited its support program, the funding side of the carry trade became too expensive to support demand for covered bonds. Sweden’s one-year interest rate swap rates began to climb on Oct. 6 and reached a nine-month high of 1.91 percent on Oct. 22.

The country’s covered bonds remain underpriced, according to Charlotte Asgermyr, an analyst at SEB AB in Stockholm. She says the bonds are trading as much as 40 basis points, or 0.4 percentage point, below their fair value.

“Swedish covered bonds have suffered severely from the problems in the funding market,” said Asgermyr. “The spread remains too wide, given the high credit quality of these bonds and the strong fundamentals of the Swedish economy.”

The disruptions caused by the Riksbank’s exit were “more dramatic than people had expected,” said Mats Hyden, chief strategist at Nordea Bank AB in Stockholm.

‘Least Bad’

“Sweden is the least bad of all the region’s financial markets; just imagine what will happen elsewhere when they start withdrawing liquidity,” said Par Magnusson, chief Nordic economist at Royal Bank of Scotland Group Plc in Stockholm. “Southern Europe is in no state to cope.”

Policy makers in Sweden decided to pull emergency support after judging the country’s financial markets were “functioning well” and that “Swedish banks have strong buffers,” the Riksbank said in June.

Sweden’s overnight market is “working again satisfactorily” and there is “no reason for the Riksbank to intervene,” Deputy Governor Lars Nyberg said, according to minutes of the bank’s October meeting published yesterday.

The Riksbank is withdrawing support as it estimates the largest Nordic economy will expand 4.8 percent this year, recouping most of last year’s 5.1 percent contraction. Still, the government warns that the growth surge may be short-lived.

‘Borrowed Time’

“We should be grateful for every month and quarter with positive growth,” Finance Minister Anders Borg said in a speech published yesterday. “After 2013, growth is living on borrowed time.”

In the euro area, a withdrawal of emergency support may have a more direct impact on lenders from the region’s peripheral states as they continue to rely on the cheap credit.

Lenders from Greece, Ireland and Portugal took 61 percent of the loans supplied by the ECB at the end of September, up from 51 percent the previous month, data from their respective central banks show.

If the ECB exits too fast, peripheral countries may have trouble finding investors willing to buy their bonds. Ireland, whose banks borrowed 83 billion euros ($115.5 billion) from the ECB in September -- 38 percent more than a month earlier -- has seen its bonds slide for 10 consecutive days. The yield on the Irish 10-year benchmark climbed over 8 percent yesterday.

‘Definitely Hooked’

Yields on 10-year debt from Portugal, whose banks held 40 billion euros of ECB loans in October, rose to a record 442 basis points yesterday relative to same-maturity benchmark German bunds. A basis point is 0.01 percentage point.

The ECB has yet to decide when to return to a bidding process offering limited funds at market rates. Any exit will cause the biggest disruptions to financial markets in Portugal, Italy, Ireland, Greece and Spain, said Halldahl. “The PIIGS banks are definitely hooked on ECB funding, as is much of the rest of the euro zone,” he said.

Addiction to ECB liquidity is “a problem” that “needs to be tackled,” governing council member Ewald Nowotny said on Sept. 6.

Given what happened in Sweden, “there is a risk in Europe that the market is not prepared for this and that many banks are going to be short of funding if spreads start getting wider,” Buddgard said. The risk is that “it becomes self-fulfilling and things will get really scary.”

To contact the reporter on this story: Kati Pohjanpalo in Helsinki at kpohjanpalo@bloomberg.net

To contact the editors responsible for this story: Tasneem Brogger at tbrogger@bloomberg.net John Fraher at jfraher@bloomberg.net

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European Central Bank President Jean-Claude Trichet

Hannelore Foerster/Bloomberg

The tensions in Sweden, which boasts the European Union’s smallest budget deficit, come as President Jean-Claude Trichet signals he’s undeterred in withdrawing the emergency measures the ECB introduced to fight the financial crisis.

The tensions in Sweden, which boasts the European Union’s smallest budget deficit, come as President Jean-Claude Trichet signals he’s undeterred in withdrawing the emergency measures the ECB introduced to fight the financial crisis. Photographer: Hannelore Foerster/Bloomberg

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A flag of the Swedish Central Bank flies in Stockholm

Casper Hedberg/Bloomberg

A flag of the Swedish Central Bank flies from a flagpole outside the building in Stockholm on Nov. 18, 2008.

A flag of the Swedish Central Bank flies from a flagpole outside the building in Stockholm on Nov. 18, 2008. Photographer: Casper Hedberg/Bloomberg