Swedish Krona: The Noose Is Getting Tighter

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Summary

The Swedish krona may be trapped into a new big devaluation cycle.

The Swedish economy finds itself at a tipping point.

Further selling of SEK could come as Eurozone banking crisis intensifies.

SEK’s new role as a liability currency in carry trades can add to the negative mix.

The Swedish krona (NYSEARCA:FXS) seems poised for a big devaluation, as deteriorating macro dynamics and the escalation of the European banking crisis create a toxic mix. After a series of unsuccessful efforts by the Swedish central Bank (Riksbank) to revive inflation, interest rates were dragged down to -0.5% as the ultimate Hail Mary. The Swedish economy (NYSEARCA:EWD) has once again reached a tipping point. On the one hand it's facing a reversal of its business cycle, while losing its competitiveness, and on the other its major export destinations are exhibiting their own domestic weakness with lackluster demand for imported goods. This means, that unless the global economy recovers, sooner or later the Riksbank will be forced to succumb in to deeper NIRP. The scene becomes even more convoluted when adding to the equation the fact that the krona has recently become the new carry trade currency. International investors now have the incentive to borrow in SEK and invest the proceeds in higher yielding currencies. This creates the perfect formula for prolonged selling pressures on the SEK.

A Turning Point for the Economy

An unexpected slump in August manufacturing PMI to three-year lows, just above the critical contraction level of 50, indicated that a potential downturn of the Swedish business cycle could be ahead.

Sweden Manufacturing PMI

Source: tradingeconomics.com

If this downturn were to materialize into a full blown recession cycle then it would be the second time that the Swedish economy would be finding itself in a downturn since the 2008 recession. In fact, since the Great Recession the Swedish economy managed to follow two strong growth cycles, with the assistance of monetary steroids. The first of these cycles peaked at 2010 with an impressive 7.7% annual growth rate and the second seems to have been topped at Q4 of last year with an annual real growth rate of 4.9%. From that point on the economy started to decelerate, while core inflation rate plateaued in 2016 under 1.5%, refusing to follow the headline's trajectory. From a consumer perspective, a deceleration in domestic demand has become evident lately, as retail sales have also started to exhibit a downward trend on a YoY basis. All these developments are coming at a time when this export oriented economy has to face an extremely challenging global trade environment making the case of a bumpy recession cycle very possible.

Sweden growth cycles

Source: tradingeconomics.com

Alarming International Trade Situation

After years and years of healthy trade surpluses and a dominant position in international trade, Sweden seems to have started losing its competitive edge. The trade balance is quickly becoming negative at a time when the krona trade weighted index is standing somewhere in the middle of its 20-year fluctuation zone.

SEK TWI

Source: BIS

This leaves ample room for it to drop even further. This negative trend in its trade balance is something that Sweden is experiencing for the first time in the last two decades.

Sweden Balance of Trade

Source: tradingeconomics.com

Except for the U.S., all other major export trading partners of Sweden - in particular countries of the Eurozone, Denmark, Norway, U.K., and China among others - have their own weak currencies, which compete directly with the krona. Perhaps this explains why the krona TWI is not as cheap as it should considering its rapidly deteriorating trade balance. This reversal of the trade balance - from surplus to deficit - will eventually start to shrink the current account surplus as well, reversing any positive underlying flows into the Swedish FX market.

Possible SEK Strengthening

All forces - domestic and international - seem to be driving the Swedish currency into a new painful depreciation cycle, with no end in sight. The question now is, if anything could reverse this negative feedback loop and actually produce the opposite effect? Counter to what happened during the 2008-2009 crisis, when the krona plummeted, the currency could now receive a boost from its newly-found liability currency status. Since there are indications that it is increasingly being used as the funding currency of choice in carry trades, in a global risk-off situation where carry trades would be forcefully unwound, a temporary, but fierce SEK buying could emerge as a result. This buying spree could also be accompanied by the outflow of capital from Europe, into other more stable markets, among which the Nordic ones stand.

Overall, the Swedish economy and its currency are being confronted with a series of macroeconomic challenges, some of which are new and menacing for this small export oriented economy, paving the way for more and bigger rounds of devaluation. Unless the biggest economies of the planet decide to accommodate their desperate monetary efforts with hyper-targeted and pro-growth fiscal action on a really large scale, the global environment will be increasingly hostile for the Swedish player, and the "release valve" of a weaker Krona will emerge as the only solution.

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