Czech koruna prepares for lift-off as speculators dive in
The Czech currency came under sustained upward pressure in the middle of January, as investors piled in on bets that faster inflation would spur the central bank to abandon a cap that has kept a lid on the koruna for the past three years.
Inflation in the Czech Republic hit a four-year high of 2% in December, the midpoint of the Czech National Bank’s (CNB) target range, but higher than the consensus 1.9% forecast and well above the central bank’s 1.3% prediction in November.
In reaching the target, the bank appears to have staved off the threat of deflation that in 2013 prompted it to intervene in currency markets to maintain the koruna at an artificially weak level of Kc27 or higher against the euro.
In spot markets late on January 17, for instance, the koruna held steady at Kc27.02 to the euro, but forward markets told a different story, with six-month contracts trading at Kc26.74 and December contracts at Kc26.60, according to Nomura.
The Czech central bank next meets on February 2, at which point it is expected to give some indication of its plan for removing the cap.
“We are seeing significant speculative positions building in the koruna through the FX forward markets, which show that investors are ramping up expectations for the central bank to drop the cap and for the koruna to rise,” says London-based UBS strategist Manik Narain.
“At the beginning of the year, six-month forwards predicted a 0.4% rise in the currency, and that’s since risen to 1%.”
Given the relative illiquidity of the Czech FX derivatives market, some investors have chosen to take exposure to the currency through the bond markets, bankers say, and two-year government bond yields were at a record low of -1.17% in recent trading, around 43 basis points lower than the German two-year yield.
To offset some of the negative returns on the bonds, some investors were receiving the cross-currency swap, which offers some pick-up for investors financing in euros.
“Cross-currency financing has got cheaper for those that have euros, so there has been big demand for swaps,” says Viktor Zeisel, deputy head of economic and strategy research at KB Group in Prague. “There have been huge inflows into bonds and I think January will be a record month for central-bank intervention.”
One of the impacts of the currency cap has been a steady accumulation of foreign currency reserves, particularly in euros, as the central bank has bought assets in that currency. Czech foreign currency reserves reached €81 billion at the end of December, compared with €46 billion at the beginning of 2013.
Excessive foreign reserves can lead to losses because, as the domestic currency eventually appreciates, the reserves lose value, suggesting the CNB would wish to limit its stores.
However, the country’s strong fiscal position means the potential loss is not a serious concern, says Zeisel.
The Czech economy is in good shape, and it posted a current-account surplus for the third straight year in 2016 (at 1.5% of GDP), on the back of growth of 2.5% last year and 4.5% in 2015.
“The outlook for the economy has improved over the past three quarters, and we expect comfortable growth of around 2.5% in 2017, sustained by a recovery in investment, positive household consumption associated with wage growth, low unemployment and higher government spending,” says Arnaud Latinier, chief emerging markets economist at TAC Economics.
“Our models indicate the koruna is around 5% undervalued.”
With the growth outlook set fair and inflation having reached the central bank’s target ahead of expectations, policymakers are expected to withdraw from currency markets sooner rather than later.
However, the central bank has says it won’t move before the second quarter, or before it is certain that deflationary pressures have evaporated.
“The use of the exchange rate as a monetary policy instrument will be discontinued when it becomes necessary to tighten monetary policy significantly as a result of very substantial inflation pressures,” the bank says in a note on its website.
“This will be achieved by discontinuing the interventions and then raising interest rates above (technical) zero.”
Lessons from the Swiss
That action was met with a surge in volatility and a 30% rise in the value of the franc in a matter of minutes, eventually leading to a drop in exports and a severe downturn in tourism. A consequence was that Switzerland only narrowly avoided falling into recession in 2015, with GDP for the year reaching just 0.8%, compared with 2% in 2014.
“The Swiss situation will be very much on the minds of Czech policymakers, but the context is very different,” says Anezka Christovova, an FX strategist at JPMorgan.
“First the removal of the Swiss peg came as a complete surprise, while the Czech central bank has done a good job of signalling to the market that it intends to act.”
She adds: “Also, in this case the market is long the koruna, whereas in Switzerland the market was short, leading to a rush to close out those positions when the peg was abandoned.”
Another factor that favours the Czech scenario is that in dropping the cap the central bank will be responding reasonably to the macroeconomic situation, and some koruna appreciation should be welcomed, says Christovova.
In Switzerland, the removal of the peg was perceived to be more about protecting the country’s balance sheet than any economic need.
Still, despite the differences between the Swiss and Czech cases, there are still risks for currency investors.
“Given that the koruna is a relatively less liquid market, we do expect some potentially large initial volatility as a result of the closing out of speculative positions,” says Christovova.