Market Strategy - CZK: Short-Term Weakness To Persist - JUNE 2017

In the two weeks since the Czech National Bank (CNB) abandoned its three-year old exchange rate cap of CZK27.00/EUR on April 6, the koruna (CZK) has erased most of its initial gains and further short-term weakness appears likely. Although we maintain our view that the currency will strengthen over the medium term, the unwinding of crowded long CZK positioning put in place prior to the cap's removal can continue exerting downside pressure on the currency. This is evidenced in the Czech bond market - the main asset class used by investors hoping to profit from CZK strength - with two year Czech bonds continuing to sell off and yields rising to their highest since mid-2016.

We nevertheless maintain our view that CZK will strengthen towards the end of 2017, on account of strong fundamentals and favourable valuations. The Czech Republic remains a regional investor safe haven in light of strong fiscal and balance of payments dynamics, the economy is set to expand at a healthy clip in 2017, and its political landscape is less eurosceptic and more stable than in regional peers such as Poland and Hungary. The currency cap was the CNB's principal monetary policy tool to keep inflationary pressures at bay, but CZK weakness may now lead to the central bank turning more hawkish and raising interest rates, further supporting the currency. Czech Republic's 9x12 forward rate agreement (FRA) is trading well above the three month interbank rate (PRIBOR), suggesting that markets are pricing in further monetary tightening following a sharp rise in Czech Republic's core and headline inflation rate to 2.2% y-o-y and 2.6% y-o-y respectively in March.

Short-Term Pain, Long-Term Gain
Czech Republic - CZK/EUR Exchange Rate (RHS) & Forward Rate Agreement, PRIBOR 3M, & 2Y Bond Yield, %
Source: Bloomberg, BMI

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