Undervalued Swedish Krona Offers Speculators Juicy Opportunities

- SEK the most undervalued currency in the G10. 

- Valuation correction, interest rats, to drive recovery.

- GBP/SEK, EUR/SEK and USD/SEK all facing losses.

© OkFoto.it, Adobe Images

The Swedish Krona (SEK) is perhaps the most undervalued currency in the G10 on a Purchasing Power Parity (PPP) valuation basis, a finding that provides speculators with compelling trade opportunies.

The Krona was -45.8% undervalued on July 17, substantially more than the next weakest currency the Japanese Yen, which itself was 33% undervalued on a PPP basis. It is now seen as a buying opportunity by analysts at Barclays, due to this gross undervaluation.

Purchasing Power Parity is thought to exert a long-term influence on a currency. It is based on a comparison of the cost of two identical baskets of goods in two different currencies. The difference effectively establishes the PPP exchange rate.

In the case of Swedish currency, the PPP rate is 45.8% higher than the actual exchange rate and the assumption is, therefore, that the market rate is too low and so it will eventually rise up towards the PPP estimate. Yet despite this, the market is uncharacteristically silent on SEK.

Valuations are not the only noteworthy sign SEK may be bottoming. Interest rates are a major driver of currencies and one of the reasons why the Swedish Krona is so undervalued is because of the extraordinarily low interest rate of -0.5% set by the Riksbank.

Generally the lower the interest rate the weaker the currency, since a low interest rate deters foreign investment. Foreign investors prefer 'higher interest rate' countries where their money is likely to make a better return.

The Riksbank took the decision to reduce rates to help boost moribund inflation. Yet the argument for lower rates has faded with a recovery of inflation, which suggests the Riksbank may be close to hiking interest rates. This would be positive for the Krona.

Recent data showed inflation rising to 2.2%. Although this was not as high as the 2.3% analysts had predicted, it is an improvement from the 2.1% seen previously and is also above the Riksbank's 2.0% target.

Above: Swedish inflation.

The uncharacteristically hot weather this summer is putting even more upwards pressure on inflation as it is drying out the hydro-electric dams which power Sweden's power grid. The drought has also hurt crops and pushed up food prices.

"One of the hottest summers on record is drying out dams and driving up power prices in Sweden. And that’s about to make itself felt in the inflation data that central bankers watch," says Niklas Magnusson, a correspondent at Bloomberg News. "Prices on Nasdaq Inc.’s power exchange have reached a seven-year high as the dry weather leaves less water to generate electricity." 

In fact, all evidence seems to be pointing to higher inflation in the future, not lower inflation, and the likely response from the Riksbank will be to raise interest rates. But the final word is of course with the Riksbank itself.

In minutes of the July 02 meeting, vote details showed a marginal shift in favour of a rate hike after another member, Henry Ohlsson, joined existing hawk Martin Floden in floating the idea of a change in policy.

Above: Excerpt from Riksbank meeting minutes.

"Henry Ohlsson entered a reservation against the decision to hold the repo rate unchanged and against the repo rate path in the draft Monetary Policy Report. He recommended raising the repo rate to −0.25 per cent with reference to the strong economic developments in Sweden and abroad. Martin Flodén also entered a reservation against the repo rate path and advocated a rate path that indicated an initial rate rise of 0.25 percentage points in September or October of this year. Mr Ohlsson and Mr Flodén also entered reservations against the decision to extend the mandate for foreign exchange interventions," says the minutes.

Yet the majority of members (4 vs 2) did not enter reservations and despite his reservation Ohlsson actually voted to leave rates unchanged, with Floden the only dissenter. The Riksbank still seems to see inflation as too fragile for them to raise interest rates.

"Measures of underlying inflation indicate that inflationary pressures are still moderate, which, according to several members, raises questions about the development of inflation in the long run. It was noted that a necessary condition for inflation to remain close to 2 per cent is for monetary policy to continue to be expansionary," says the minutes. "The forecast indicates that slow rate rises will be initiated towards the end of the year. At the same time, the majority emphasised that monetary policy needed to proceed cautiously with rate rises in this situation."

Can Charts Have the Last Word?

More evidence pointing to a recovery by the Krona comes from the charts, which suggest the currency may recently have bottomed out against a number of rivals. The signs are probably clearest versus the Euro.

The EUR/SEK formed a very bearish 'key reversal' month in May when it peaked and then made a new low all in one month. Key reversal's are often reliable indicators of market tops.

The fact the exchange rate then followed through to the downside and broke below the previous lows is more evidence of a reversal. The fact the follow-through has slacked off since then, however, is not particularly positive and we would ideally like to see a re-break of June's lows at 10.09 for confirmation of a reversal and the start of a new bear trend.

Above: EUR/SEK rate shown at monthly intervals.

With GBP/SEK there is an almost identical set up to the one above. The pair formed a bearish key reversal month in May and then broke below the lows in June, showing good follow-through, but here again prices have since recovered a bit. We would likewise like to see a re-break below the 11.47 lows for confirmation of more downside and the start of a longer-term bear trend.

Above: GBP/SEK rate shown at monthly intervals.

Finally, USD/SEK is also looking bearish and toppy, though for slightly different reasons. There is a possibility the pair may be forming a head and shoulders pattern like the one below.

Above: Head and shoulders pattern. Source: LuckScout.com.

This is a bearish reversal pattern which appears at market tops. The confirmation for a change of trend is a break below the neckline, drawn by joining the troughs at the bottom of the pattern as shown on the chart below, with a deep decline expected of a similar magnitude to the height of the pattern extrapolated lower, following the break.

Above: USD/SEK rate shown at monthly intervals.

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