As financial markets eagerly anticipate central bank rate cuts, the February edition of the Mark-Up delves into the transition from carry trades to valuation-driven strategies, highlighting why SEK stands out as our top pick to capitalize on this transformation.

1. SEK: Capturing the Shift from Carry to Value Within Global FX Harry Purdie - 05/02/2024
Carry as King
Thematically, over the last 18 months, global FX has been dominated by carry, which has been the
primary driver of currency valuations and central to strategies delivering some of the highest returns.
Occasionally, short-term macro themes and events provided temporary excitement, yet many of them
lacked staying power and gradually lost their influence on price action over time. No such similar fate
could be ascribed to yield divergences across global central banks and the opportunity it offered market
participants in structuring attractive carry basket trades.
While central banks were broadly aligned within a global hiking cycle, key nuances created an
environment highly conducive to carry trades. Most important were the divergences in central bank
policy, both in terms of speed of hiking and also magnitude of hikes themselves. Hawkish EM central
banks in Latin America, notably Mexico, Brazil, Chile and Colombia, took the lead by implementing
policy rate hikes as early as 3Q2021. Bringing up the rear so-to-speak, was the Scandinavian fraction of
G10 central banks, with the Riksbank and Norgesbank remaining some of the most dovish in their speed
and magnitude of hikes. The most stark outlier was and continues to be the Bank of Japan, which has
remained accommodative in its monetary policy stance throughout the entire duration of the global
hiking cycle.
Variations in the scale and speed of central bank hiking cycles widened yield spreads between hawkish
and dovish institutions, creating appealing opportunities for market participants to monetize attractive
yields on constructed carry baskets. High-yielding currencies such as MXN and BRL, with robust
fundamentals including a strong balance of payments position, rapidly became favourites for global
investors seeking carry yield. Within the G10 space, GBP and NZD - despite both having weaker
fundamentals from a macro standpoint - have also been supported by this carry theme as a result of
more hawkish central banks and higher policy rates. Carry chasing behaviour saw these high-yielders,
within EM especially, become significantly richer as they received large capital inflows and re-priced
materially upwards.
On the other side of this trade were a collection of currencies that rapidly became popular choices as
funding currencies. These funders were characterised by central banks where the path of rate hikes was
less aggressive and lagged behind their counterparts - JPY and SEK were prime candidates within this
criteria. The attractiveness of selling these low-yielders to monetise yield spreads saw the value factor of
these currencies largely collapse, with them becoming increasingly cheaper and reaching multi-year
lows on major crosses. JPY in particular saw valuations eroded substantially as its negative interest rates
made it a consensus funder of choice for market participants, reaching lows on the USD pair not seen
since 1990.
Given the performance of FX carry, linked to the yield on the basket, it is no surprise that 2022 and 2023
represented bumper years for FX carry strategies. Although carry is typically a high beta strategy, helped
by falling volatility, it ultimately proved to be resilient to inflation and served as a diversifying trade within
the FX market in 2022 and 2023.

2. SEK: Capturing the Shift from Carry to Value Within Global FX Harry Purdie - 05/02/2024
Shifting Central Banks & Implications for Strategy Rotation
However, the conditions that aligned perfectly to allow FX carry to be such an effective strategy within
the last two years are gradually shifting. The challenge posed by, in many places, multi-decade high
levels of inflation and the fear of higher long-term inflation expectations becoming entrenched, saw
central banks globally respond with, on aggregate, the fastest and most extreme central bank hiking
cycle in recent history. With the most hawkish of the central bank contingent leading and the more
dovish lagging, this discrepancy created wide yield divergences, which effectively was the lifeblood of
any FX carry trade.
Yet with inflation across the board having tempered and coming back towards, and in some places
already under, central bank’s targets, the need for such restrictive policy rates is diminished. In real
terms, rates across most G10 economies are in fact more restrictive now than they were at this point last
year. Fuelled by the matter becoming an increasingly prevalent point of conversation within most central
bank meetings, such has naturally led to market expectations for central bank rate cuts across the
board. 2023 saw 80% of central banks globally hiking yet this is strikingly juxtaposed by the reality of
2024, a year where now 80% of central banks are expected to cut policy rates.
Outperformance of Carry Trading Currency Strategies vs. Value Strategies
Source: Bloomberg
This upcoming global easing cycle will provide a more challenging environment for FX carry, with a
reduced overall level of yield to monetise, making the strategy less attractive. Whilst a broader hiking
cycle saw yield divergences, inversely a broader easing cycle will result in yield compression. For those
who led in the hiking cycle, the inverse of this will play out in the easing cycle. This reverse dynamic is
already visible within LATAM, where Chile, Colombia and Brazil - countries that were amongst the first to
raise policy rates initially - have already begun easing. This turn of events, as continually realised, will
cause yield spreads on carry baskets to converge. With reduced returns offered by carry baskets, the
attractiveness of carry as a strategy will, broadly speaking, diminish.

3. SEK: Capturing the Shift from Carry to Value Within Global FX Harry Purdie - 05/02/2024
It would be wise to clarify that there is likely still a window where carry remains an attractive strategy;
however, the basket of applicable currencies continues to narrow, and even on remaining candidates
where yields remain substantial, yield spreads are converging. We view BRL and MXN as the two
remaining prime candidates, offering attractive spreads on crosses against low-yielders, backed by
strong macro fundamentals and with valuations not excessively stretched.
By contrast, at this juncture we’re also flagging various currencies which have been beneficiaries of a
carry-friendly environment yet where this regime shift will be more harmful to their status as carry
favourites. Currencies such as both COP and HUF, where the pace of easing somewhat raises concerns,
combined with already rich valuations, would suggest erosion of some of 2022’s gains.
Nevertheless, this constitutes a significant regime shift in the macro backdrop, one which has
increasingly come into focus since 4Q2024 and will continue to grow in importance as the leading driver
for FX valuations within 2024. With this theme gaining in significance, we are less constructive on carry
looking ahead into the year and instead place greater focus on the rotation to value. Yield seeking
behaviour during 2022 and 2023 saw valuations become stretched in both directions; funders became
excessively re-priced to the downside whilst high-yielders grew rich as capital moved in tandem with
yield spreads. We expect the onset of a global easing cycle, to catalyse noteworthy mean reversion in
valuations at both the cheap and expensive ends of currencies.
Given our view that an easing cycle will provide further momentum to the ongoing carry to value rotation,
the remainder of this report will look at how best to monetize this. Our chosen FX recovery theme
candidate - that we believe is best placed to benefit from this convergence of global yields, subsequent
mean reversion in valuation terms and lowered interest rates - is SEK. A combination of cheap valuation,
a compression of global yield spreads, strong fundamentals, and the amplified impact of upcoming rate
cuts given the highly levered nature of the economy, represent a strong confluence of catalysts that
underpin our constructive medium-term view on SEK.

4. SEK: Capturing the Shift from Carry to Value Within Global FX Harry Purdie - 05/02/2024
SEK Recent Performance
Since January 2021, SEK has lost 22% on the USD pair and 11% on the EUR cross. A major
depreciating force for the SEK following post-Covid highs in 2021, was the deteriorating economic
outlook for the Swedish economy, where macroeconomic imbalances left the Swedish economy highly
vulnerable to a tightening in monetary conditions. The economy remained hostage to unresolved housing
market tail risks which constituted a major point of concern. The impact of these structural problems that
had built up over the years came to the fore as inflation and rates rose rapidly following the fallout from
the Ukraine conflict and pandemic.
Housing Market - Valuations & Debt
Years of ultra-low borrowing costs have been vital in facilitating growth across global housing markets
over the previous decade, with this no different in Sweden. A period of cheap credit between 2008-2021
saw real house prices in Stockholm rise by almost 70%, with demand for owner-occupied homes
supported by falling mortgage rates. Alongside low-cost borrowing, demand has also been aided by
supportive government policy including effectively non-existent real estate taxes and generous mortgage
tax relief. Important to note is that explosive growth in Swedish housing prices has not solely been
driven by demand-side factors; Sweden’s housing market has also been dominated by shortages, with a
uniquely undersupplied rental market as a result of tight regulations meaning a lack of viable alternatives
for prospective owners. A combination of these factors has contributed to a housing market where
prices in the capital have almost quadrupled in the last twenty years, vastly outstripping wage growth
and posing a challenge in affordability terms.
Given high costs of housing as a function of cultivated demand and a structural supply deficit, stretched
affordability has unsurprisingly seen financing via debt play a central role within the Swedish housing
market. Within Sweden household debt levels are high, among the highest in the EU at around 200% of
disposable incomes, much of which is mortgage debt.
Housing Market - Variable-rate Mortgages
A key concern as surging global inflation forced central banks to adopt more hawkish policy stances and
embark on hiking cycles, was how the Swedish housing market would respond to higher rates. Rising
interest rates typically result in downside for housing prices, given that higher costs of credit in turn
pushes up mortgage rates reducing the affordability of property and with it property prices. Sweden,
however, was particularly vulnerable when evaluating the capacity to stomach this higher cost of credit.
In Sweden, this had a significantly amplified effect due to the profile of mortgages, where around 60%
are financed with floating rates, with many of the rest as short-term fixed rates. In most developed
economies, a greater proportion of fixed rate mortgages ensures there is at least a lag in pass through of
monetary policy to households, as higher rates are then only passed on via mortgages once it comes to
refinancing. However, a high incidence of floating mortgages in Sweden meant a rapid transmission of
rate rises to households, with higher financing costs felt instantly as variable rates were re-priced higher
to reflect the Riksbank policy rate.

5. SEK: Capturing the Shift from Carry to Value Within Global FX Harry Purdie - 05/02/2024
Housing Market - Impact on the Economy & SEK
This sensitivity of households to higher rates as a result of variable mortgage profiles in conjunction with
high levels of accumulated household debt, meant that the majority of households in Sweden were
particularly vulnerable to higher interest rates. Ultimately, excessive housing valuations alongside a high
reliance on short-term mortgages represented a dangerous combination - with home affordability already
stretched at low interest rates, higher rates unsurprisingly translated to a drop in local demand.
Short-term owners, instantly feeling the higher financing costs, were forced to accept lower prices when
selling. Stemming from this collection of factors, fire sales took place due to this reduced affordability
which saw house prices in Stockholm re-price faster and more severely than elsewhere.
Falling Global Housing Prices
Source: UBS
Per UBS, on average of all cities, within 2023, inflation-adjusted home prices saw the sharpest drop
since the Global Financial Crisis in 2008. Sweden was particularly badly hit; house prices fell on average
15% since the peak during spring 2022, which marked a bigger drop than in 2008, with some regions
experiencing far more severe falls. The impact of the fall in household prices was evidently reflected in
household consumption, which fell by 2.5% per Nordea, the largest decline since the 1990s outside of

6. SEK: Capturing the Shift from Carry to Value Within Global FX Harry Purdie - 05/02/2024
the pandemic period in 2021. This effectively demonstrates both the scale and pace at which higher
policy rates were transmitted to households and the impact on the real economy.
Transmission of Swedish House Prices to Household Consumption
Source: Nordea, SCB, Macrobond
Idiosyncrasies of the Swedish economy meant that SEK found itself in a precarious situation, exposed to
a dangerous feedback loop which drove continued weakness. Given Sweden’s profile as a small, open
economy, the inflation rate is highly exposed to fluctuations in the exchange rate. A spike in global
inflation led to high levels of inflation within Sweden, causing the Riksbank to adopt a more hawkish
policy stance to restore price levels to their mandated target. Due to the highly levered nature of the
Swedish housing market, this tightening led to a significant decline in house prices, impacting growth
and the economy which in turn hurt SEK. Whilst a stronger domestic currency can help moderate the
cost of imports and lower the inflation rate, a weak SEK instead led to increased currency driven inflation
which drove further Riksbank tightening, reinforcing this flywheel effect.

7. SEK: Capturing the Shift from Carry to Value Within Global FX Harry Purdie - 05/02/2024
Recovery Thesis
With the interest-sensitive Swedish economy having come through the challenges of recent years’
inflation and interest rate struggles without sliding into a deeper crisis such as that of the early 1990s, we
now turn our attention to what lies in front. Looking ahead, there remains three central narratives that
stand to benefit SEK performance: attractive valuation, convergence of global yields and the outsized
effect of lower rates on the economy.
Attractive valuation
In valuation terms, the Krona appears undervalued, with ample room to recover on the basis of long-term
economic fundamentals with little need for carry advantage. Historically, SEK has depreciated around
16% on average in trade-weighted terms during a recession: having experienced recession conditions,
the currency bottomed at 15% from the post-Covid high and from a recession sequencing angle, the
growth slowdown now has been well priced into the currency. The Krona still appears cheap to growth in
the long-term, given domestic and relative growth alongside global cyclicals, even despite the valuation
gap now sitting as closer to fair value based on rates and growth, than as we entered 4Q2023. We see
this as a strong position from which SEK can continue to rebound from undervalued levels, especially in
H2 of this year.
Yield Compression
In addition to SEK valuation being attractive, the wider theme of yield compression will serve as an
additional tailwind. Over the past two years, in an environment where carry dominated returns within FX
strategies, SEK valuations bore the brunt of its relatively lower policy rate. Yielding lower than almost all
of its G10 counterparts, let alone higher beta EM high-yielders, a cheap SEK was widely used as a
funder and sold as a result. It made little sense to buy SEK given its properties as a risk-sensitive,
pro-cyclical, high-beta currency within a risk-averse macro environment where terminal policy rates
weren’t yet in sight, the inflation outlook remained highly uncertain and a hard landing was forecasted for
the global economy. Additionally, for much of the past two years and even today - with the policy rate in
Sweden at 4% and 5.25-5.5% in the US - it has effectively paid to be underweight SEK against more
defensive currencies such as USD.
As yields decrease, the structural challenge facing SEK will diminish as the narrower yield spread makes
carry trades less attractive. Just as the Riksbank were slower and less aggressive in raising rates to
curtail inflation, the market expects them to be slower and less aggressive when bringing rates down.
Currently rates markets price the Riksbank as starting to cut after (June) the Fed (May) and at a lesser
amount this year (100 bps vs 125 bps). This narrowing of yield spreads is far greater versus some EM
high-yielder counterparts - compared to February 2023, policy rates have come down 400 bps (Chile),
200 bps (Brazil) and 225 bps (Hungary). Even with a Riksband that is currently on hold and now actively
talking about rate cuts in the coming year, yield convergences between SEK and other higher-yielding
currencies is awaited by market participants. Looking ahead for this wider yield compression theme to
play out, we expect this to result in reduced selling of SEK allowing valuations to continue to revert.

8. SEK: Capturing the Shift from Carry to Value Within Global FX Harry Purdie - 05/02/2024
Lower Rates
The benefit of falling global rates for SEK is not limited to compressed yield spreads as a source of
support for the Krona. With awareness of the systemic risk that the housing market poses to the wider
economy, Riksbank easing will be viewed as reducing that eventuality, a bullish outcome for the
economy. Given Sweden’s highly levered economy, cuts from the Riksbank will allow rate-sensitive
sectors of the economy to recover, boosting growth and continuing to erode the recession risk premium
that was built into the currency last year. Cuts from the Riksbank are expected from Q2 onwards (more in
Riksbank Policy Stance section below) and mortgage rates which have already peaked, are both
developments that line up with this view.
In the same way that SEK found itself in an aforementioned reflexive feedback loop last year which
spurred momentum to the downside, there now is an opportunity for the reverse to play out. Looser
policy will positively impact growth via the housing market, which will act as support for SEK and in turn
help moderate currency driven inflation, allowing further Riksbank easing. Given the highly levered nature
of Sweden’s economy, in this instance a central bank on pause and starting to shift dovish feasibly
represents a tailwind rather than a headwind for the currency.
Riksbank Policy Stance
The Riksbank delivered a policy update last week, keeping rates at 4% as expected and clearly
signalling that their tightening cycle is over. Where previously Riksbank communication had remained
hawkish to offer support for Krona appreciation from ‘unjustifiably’ weak levels, they adopted a more
dovish stance on the day. Despite no new rate path being provided on the day, the Riksbank was dovish
in their rhetoric, with both the statement and press conference hinting at the risk of earlier cuts than
forecast.
Swedish inflation (CPIF) forecasts
Source: Nordea, Macrobond

9. SEK: Capturing the Shift from Carry to Value Within Global FX Harry Purdie - 05/02/2024
Inflation (CPIF) is expected to stabilise at close to the 2% target during H1 of the year, dropping below
the target in H2. This will allow the Riksbank to normalise monetary policy, particularly given that
long-term inflation expectations remain anchored close to their inflationary target. Riksbank policy
guidance suggested earlier cuts could come if inflation developments are favourable. The first fully
priced cuts in response to slowing inflation and muted growth, are expected in H2, with 15bps priced in
over the next three months and an additional 60 bps over the next six.
Whilst the SEK weakened on the day - driven largely by the more than expected QT increase which is
not as important for the currency - this is precisely the outcome we were looking for to continue being
constructive on the currency in line with our view.

10. SEK: Capturing the Shift from Carry to Value Within Global FX Harry Purdie - 05/02/2024
Forecast and Risks to the View
The return of growth will be contingent on the full transmission of rates to the economy with an
acknowledgement that interest rate levels will remain higher than pre-pandemic, meaning households
and businesses will be required to adapt to higher funding costs. Given this, our constructive view is
focused more in 2H2024, with SEK likely to still struggle until Riksbank and wider G10 central bank cuts,
especially with the end of FX Sales from the Riksbank. From H2, as global rate cut cycles start we expect
more favourable risk sentiment conditions to benefit cyclical, higher-beta currencies such as SEK
allowing outperformance - we are targeting 10.5 on the EUR/SEK cross in 4Q2024.
EUR/SEK FX Cross
Source: FT
Fundamentally our constructive stance on the Krona is premised on a soft landing for the global
economy, with major DM central banks expected to start cutting policy rates as inflation trends towards
targets. The main downside risk for this thesis is a scenario where inflation proves more stubborn than
expected in returning to targets or begins ticking upwards once more, requiring global interest rates to
remain higher for longer.