Sweden Debt Market Tensions Show ECB (and FED)What Liquidity Exit Brings

Nov. 9 (Bloomberg) -- 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.

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Yeah, you better prepare for a tsunami to come....

 

just another bubble created by a central bank that is about to pop. if people do not get the pattern by now the this planet gets better ruled by amoebas...

just imagine how it may look like in US with accommodative Fed - as opposed to relatively tight ECB...

 

Fear of default.