SEK: G10’s Best Performing Currency Has Cyclical And Structural Support

Summary

• SEK outperformance unrelated to Sweden’s no-lockdown policy.
• Riksbank’s 2020 hawkishness contrasts 2014-2019 dovishness.
• The positive basic balance, the rise in NIIP, and the strong fiscal position improve SEK resiliency.

Market Implications

• Fundamentals support the SEK, but near-term performance will depend on the global growth rebound in 2021.

Introduction

The Swedish krona is the best-performing G10 currency in 2020. For a small open economy to do so well during the worst global recession since World War II is remarkable. Could it have something to do with their unique Covid-19 strategy? While most countries imposed strict lockdowns in Q2, Sweden took a more relaxed approach based on voluntary action.

Sweden’s Covid-19 Strategy

Sweden was one of the few economies to implement no lockdowns. Instead, it relied on voluntary social distancing (Chart 1). But when the second wave hit, the country imposed stricter restrictions because immunity in the population appeared lower than hoped. According to Dr Tegnell, the architect of Sweden’s no-lockdown strategy, there are no signs of immunity in the population. In fact, 15% of the population in Stockholm have developed antibodies in July, well below the 55%-80% estimate for herd immunity.

As expected, Sweden has the highest Covid-19 case numbers and death rate among Nordic countries (2.6%/0.07% versus the Nordic average of 1.0%/0.01%). But those numbers are lower than France (3.3%/0.08%) or the US (4.3%/0.09%). One possible reason Sweden managed to avoid exponential growth in case numbers is that people have pro-actively reduced their physical interactions. Apple mobility numbers indicate that the velocity of people in Sweden dropped as much as in Norway or Germany, despite stricter restrictions in those latter countries. Given the similar drop in activity levels Sweden’s economy did not really perform better than others in Europe (Chart 2). Actually, the cumulated growth in Q2/Q3 (-3.5%) was much lower than its Nordic neighbours (-1.1%), Poland (-1.8%) or Germany (-2.1%).

In light of this, the impact on the Swedish krona has been very moderate. Indeed, during the first lockdown period in Europe, SEK weakened by 4.5% (vs USD) compared to EUR by 3.8%, GBP by 4.8% and PLN by 9.2% (Chart 3).

So how can we explain SEK outperformance in 2020?

2015-19

To understand the Swedish krona’s outperformance in 2020, we need to understand why SEK bulls have continuously been disappointing since 2014. Their rationale was based on the positive output gap and the cyclical recovery in Europe. Inflation should rise, while SEK will also benefit from the rebound in global growth. SEK is one of the most cyclical currencies as Sweden’s exports are geared towards inputs used in the early phase of the global cycle.

However, despite falling policy rates, quantitative easing and a weakening of the currency, inflationary pressures never really materialized in Sweden. The domestic inflation rate reached 2% in 2018, but this was mainly driven by the cyclical recovery in Europe in 2017(Chart 4). Domestic inflation in Sweden depends more on euro area developments than domestic conditions.

Therefore, when global/EU growth started to slow in 2017, the Riksbank continued to maintain a very dovish monetary policy. Actually, from 2014 to 2019, the Riksbank has pursued a more expansionary policy than the ECB despite the stronger economy in Sweden. During this period, the SEK weakened by roughly 15% against the EUR (Chart 5).

Monetary Policy in 2020: Cautious

In January 2020, the Riksbank decided to end the ‘negative rate’ experiment and increase the repo rate in positive territory. During the Covid-19 crisis, they strongly refrained from cutting the policy rates below 0%. Indeed, the 2015-19 experiment provided mixed results. Negative rates were off the table for many central banks this year with none taking rates deeper into negative territory. For the Fed, BoC, RBA, and Norges were cut before reaching the lower bound.

The interest rates differential between the SEK and the G10 currencies therefore improved (from -0.90% in 2019 to -0.20% in 2020) and supported the Swedish krona. Even on QE, the Riksbank was less aggressive this time than other G10 central banks. Its balance sheet increased by roughly 10% this year, which was at the lower end of the G10 range. Lastly, policymakers have seemed fairly unconcerned about the SEK strengthening in 2020. The Riksbank may be too optimistic, but what a change in the reaction function compared with 2014-19!

Fiscal Policy: Aggressive

The fiscal response has been aggressive. The announced measures account for 13% of GDP, which should translate into a fiscal impulse close to that in the euro area. However, the very important difference between Sweden and the euro area is the fiscal buffer (Chart 6). For 2021, the government plans to run a budget deficit of 3.5% of GDP, but it will have the ability to increase this amount if required. Indeed, public debt in Sweden will account for only 39% of GDP compared with almost 100% in the euro area. That will probably be an important driver of the currency in 2021.

Balance of Payments and NIIP: Structural Support For SEK

Let’s examine the BoP dynamic. The current account increased from 2.5% in 2018 to 5% in 2020, the highest since 2013, driven by improvement in the trade surplus and the primary income. Stable FDI lead to an improvement of the basic balance to almost 5% of the GDP (Chart 7). Moreover, the rise in primary income is a consequence of the dramatic rise in Sweden’s net international investment position (NIIP) since 2014.

The positive basic balance creates structural SEK inflows. But what’s more interesting is the impact of the rise in NIIP. Foreign assets tend to be repatriated during economic downturns, which is a key characteristic of safe haven currencies like the JPY or the CHF. Sweden’s NIIP (25%) is still well below that of Japan (67%) or Switzerland (117%), but it could improve SEK resilience during future periods of higher volatility (Chart 8).

Conclusion

Macro investors have long awaited the end of the negative rate experiment and the shift in Riksbank stance. The narrowing of interest rates differential and the rebound in global manufacturing have been two key drivers of the currency this year. Moreover, the improvement in the basic balance will be an important SEK support in a world of low interest rates, while the rise in NIIP and the strong debt profile will improve SEK resiliency.

However, SEK remains a pro-cyclical currency, and the near-term performance will still depend on the global economy rebound and risk sentiment.