$5 Billion Mystery Sets Stage for Bets on Swedish Bond Squeeze

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The Swedish National Debt Office will soon need to explain why it alone among main prognosticators predicts a 42 billion kronor ($5 billion) hole in government finances next year. 

Its answer could force the country’s central bank to expand its quantitative easing program into other types of bonds next year, even the “forbidden” covered bond market, according to Danske Bank.

“There’s a risk that there’ll be a considerable squeeze in the Swedish bond market,” said Michael Grahn, a fixed-income analyst at Danske Bank in Stockholm.

The central bank’s efforts to pump money into the economy and bring back inflation risks running headlong into a bond shortage as it by year end will own about 40 percent of the government bond market. Expanding government bond buying into next year, which Danske, SEB and Swedbank all expect it will, may be dependent on continued new bond issuance.

But the debt office will most probably need to cut its forecast for issuance of bonds next year to about 60 billion kronor from 77 billion kronor, according to Danske. The agency, which issues its next forecast in October, has by far been the most negative among prognosticators when it comes to deficits. In fact, anticipated deficits are now disappearing amid higher-than-predicted tax revenue and lower costs to handle refugees.

While the Riksbank so far says its QE program is working as intended, it, as well as the debt office, have lately admitted that the bond purchases could soon start affecting liquidity even as it already has reduced its purchases.

First Deputy Governor Kerstin af Jochnick said recently that the Riksbank is in talks with the agency on possible market effects of its government bond purchases. The Riksbank is also discussing what other asset types it could purchase if it needs to make policy more expansionary. Technically, the bank could extend its purchases into covered bonds, corporate or municipal bonds, af Jochnick said.

Danske Bank expects policy makers will announce an extension of its government bond purchases into 2017, buying 30 billion of government bonds in the first half, compared with 45 billion in the six months through December. SEB AB expects the same size of QE extension, and Swedbank also sees government bond purchases to continue at least in the first half of 2017.

That could force them into the covered bond market, driving down mortgage yields further and stoking the already red-hot Swedish housing market.

“If the Riksbank thinks it has to continue with bond purchases there’s a risk that they’ll need to utter the forbidden word: the covered bond market,” Grahn said. “Perhaps they’ll flag that possibility later this year. If household lending growth has slowed down perhaps it becomes less controversial.”