Czech Republic: Receive 2y2y fwd CZK rates vs. EUR

EM Strategy Desknote Czech Republic: Receive 2y2y fwd CZK rates vs. EUR  At its September meeting, the Czech National Bank (CNB) kept policy rates unchanged. It suggested that the timing of future rate hikes depends on the path of EURCZK.  The sluggish reaction of the CZK to August’s rate hike can, in our view, be attributed to the high level of excess liquidity in the banking system.  The tightening of the CZK-EUR basis could trigger a rise in the CZK, curbing above-target inflation and limiting the need for higher rates.  Even if inflation pressures persist, we see benefits for the CNB in using alternative policy tools to tighten liquidity (rather than raising rates), including FX intervention.  We continue to think that the curve beyond the 2y is pricing in too many rate hikes and we recommend receiving rates in the belly of the curve.  Trade: Receive CZK 2y2y fwd rates over EUR 2y2y rates at 117bp, targeting 100bp (-3bp carry per quarter) At its 27 September meeting, the Czech National Bank (CNB) kept policy rates unchanged, although three of the seven board members voted for a rate hike. Despite the close vote, EURCZK finished the day where it started: above 26. In fact, the pair has struggled to break below this level since the CNB hiked rates in August. The CNB's assessment of monetary conditions takes into account both the interest rate and FX channels. While the interest rate policy channel has worked well, the FX channel has not such that, this week, CNB Governor Rusnok stressed that the exchange rate is the main factor that will determine the timing of future rate hikes. Chart 1: Recent tightening of CZK-EUR basis could support CZK appreciation, which would soften the need for rate hikes to the extent currently priced in Chart 2: Beyond 2019, divergence between EUR and CZK rates continues, raising a question of its sustainability, should the CZK appreciate in line with CNB assumptions Source: Bloomberg, BNP Paribas Source: Bloomberg, BNP Paribas This document has been produced by: Piotr Chwiejczak BNP Paribas London Branch FX & IR CEEMEA Strategist +44 20 7595 8715 Sai Uluri BNP Paribas London Branch FX & IR CEEMEA Strategist +44 20 7595 1872 Please refer to important disclosures at the end of this report www.GlobalMarkets.bnpparibas.com Tuesday, 14 March 2017 Why has the FX response been so sluggish? In our view, the failure of the CZK to appreciate can be attributed to the high level of excess liquidity in the banking system which, in turn, is due to the CNB’s FX intervention when the EURCZK floor was in place. This week, Mr Rusnok referred to the CZK as overbought which, to us, is in line with previous comments expressing concern about the positioning in FX built up during the EURCZK floor regime. We think that the main obstacles preventing an appreciation of the CZK from its current level are the widening of the CZK-EUR basis since June and the fall of the FX term premium, which was driven by the expiry of a large amount of T-bills at the beginning of September. However, over the last two weeks, the FX basis has started to tighten (Chart 1) which could prove to be the trigger for CZK appreciation. Moreover, amid strong economic activity, there is a possibility that Czech firms will issue more EUR-denominated eurobonds and swap them back into CZK, which would work in favour of tighter basis. In recent months the CZK has also been held back by a strong appreciation of the EUR. Now, however, with US rates rising, there is a risk of a sell-off in the EUR, which could lead to a faster appreciation of the CZK against the EUR. How might the CNB respond in November? If the tightening of the basis builds downward momentum in EURCZK in the coming months, the CNB may again decide to keep policy on hold at its next meeting on 2 November, with the view that koruna strength will help curb above-target inflation. Moreover, external price moves will also limit inflation as commodity prices remain subdued after falling sharply since the start of the year (though we note that, as per its recent communication, the CNB already takes this into account in its projections). On the other hand, if inflation data continue to surprise to the upside and EURCZK stays range-bound, the case for policy tightening would rise. However, even under this scenario, we think that the CNB could opt to use alternative policy tools, given that adjusting the interest rate alone has proved to be relatively ineffectual with regard to triggering a sustained fall in EURCZK. One possible policy alternative is for the CNB to shrink the size of its balance sheet via FX auctions. This would not only increase the efficiency of the FX channel but also correct th