CZK meltdown: Is the past catching up?

The Czech koruna is sharply down and EUR/CZK is above 26.00. What used to be the safe harbour in times of stress within the CEE region has turned into an underperformer.

The problem for the koruna is that positioning is finally catching up. Foreign holdings of Czech government bonds - behind 40% clearly shows that the koruna has been persistently and chronically overbought, making it vulnerable in times of stress. While the CZK weathered the 2019 global trade war storm relatively well (EUR/CZK did not move above the 26.00 level), current market jitters are taking a heavy toll.

This is due to:

(a) Across the board deleveraging, which has made overbought currencies particularly vulnerable (CZK in the CEE, RUB in the wider EMEA space or MXN in the LatAm region),

(b) Markets aggressively pricing in Czech central bank rate cuts, with the central bank being one of the few with ample room to ease monetary policy.

While there isn’t much the Czech authorities can do about the positioning, they have power over rate cuts. Although from a bird's eye view, the case for central bank rate cuts is rising, from an idiosyncratic point of view, any larger scale easing cycle would in our view lead to a CZK meltdown.

The currency is already very vulnerable due to the positioning and should the central bank take away the key anchor behind CZK (the yield advantage), the exodus from Czech asset markets could be rather pronounced. Indeed, based on our conversation with investors last year, the yield advantage was the key reason why investors remained invested in CZK during the 2019 global trade war.

Bar the implications for the currency, we also don’t see rate cuts as the best remedy for the current Czech economic situation.

A more effective measure would be a lower counter-cyclical capital buffer to support credit availability

As Governor Jiří Rusnok mentioned this week, rate cuts might not help the economy much as a small deceleration in lending costs won’t be a game-changer for companies, which mainly need to have access to credit. Credit availability will be considered as more crucial than lending costs itself.

A small rate cut would aim to signal coordination between the central bank and the government (as was the case in the UK), but a more effective measure would be a lower counter-cyclical capital buffer to support credit availability.