CZK to Gain as CNB Poised to Hike Rates

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The Czech National Bank meets tomorrow and is expected to be the first European to hike rates.  The economy remains robust, and the koruna has appreciated slowly but steadily since the floor was eliminated. 

POLITICAL OUTLOOK

Long-standing tensions between Prime Minister Sobotka and Finance Minister Babis finally led to a blow up.  Babis stepped down as Finance Minister while Sobotka stepped down from leading the Social Democrats and passed the baton to Lubomir Zaoralek.

The next general election will be held in October.  Polls show Babis’ ANO leading Zaoralek’s Social Democrats by wide margins, some as high as 20 percentage points.  ANO was the winner of regional elections last October, and clearly remains the frontrunner.  Babis has said he will govern with any party except the Communists and the conservative TOP-09.

The EU has become a very touchy subject, as Czechs are overwhelmingly skeptical of the benefits.  However, the Czech Republic appears to fall far short of the anti-EU stances shown by neighboring Hungary and Poland.  Zaoralek is following a pro-EU platform whilst Babis has taken a more confrontational approach, complaining of EU “meddling” and rejecting euro adoption.

The Czech Republic scores very well in the World Bank’s Ease of Doing Business rankings (27 out of 190).  It does less well in Transparency International’s Corruption Perceptions Index (47 out of 176 and tied with Cyprus and Malta).  Perhaps this helps explain why Babis’ message of fighting corruption and bureaucratic waste seems to resonate with the voters.

ECONOMIC OUTLOOK

The economy remains robust.  GDP growth is forecast by the IMF to accelerate modestly to 2.8% in 2017 from 2.6% in 2016, before slowing to 2.2% in 2018.  GDP rose 4.0% y/y in Q1 (3.0% seasonally adjusted).  While monthly data so far in Q2 suggest some modest slowing, we see upside risks to the growth forecasts.

Price pressures remain elevated, with CPI rising 2.3% y/y in June vs. 2.4% in May.  July CPI is due out next week and is expected to remain steady at 2.3% y/y.  If so, inflation will have remained at or above the 2% target for the eighth straight month.  However, it remains within the 1-3% target range.

This supports the case for higher rates, and we believe CNB will hike this year.  Many expect it to hike rates 20 bp to 0.25% tomorrow.  However, the market is split.  Of the 22 analysts polled by Bloomberg, 12 see a 20 bp hike and 10 see no change.  We lean toward no hike now, but view it as very likely at the next meeting on September 27.  Note that the central bank estimates that a 1% CZK appreciation has an impact that’s equivalent to a 25 bp rate hike.

Fiscal policy has remained prudent.  The budget moved to a surplus equal to 0.6% of GDP in 2016.  The OECD forecasts the surplus at 0.4% of GDP in 2017 and 0.6% in 2018.  Babis has pledged to cut taxes, adding that a balanced budget isn’t “a mantra.”

The external accounts remain in good shape.  Low oil prices have helped limit imports, while strong EU growth has boosted exports.  The current account surplus was about 1.1% of GDP in 2016, and is expected by the IMF at 1.2% in 2017 before narrowing to 0.7% in 2018.

Foreign reserves exploded due to the FX intervention that was needed to maintain the EUR/CZK floor.  They rose to $142.5 bln (EUR124.9 bln) in June, up from $47.5 bln (EUR34.8 bln) in October 2013 (the floor was put into place in November 2013).  Reserves have continued to rise after the floor ended, but much of that is due to valuation effects from the stronger euro.

INVESTMENT OUTLOOK

The EUR/CZK floor “around” 27 was in place from November 2013 to April 2017.  The end of the floor was so well-telegraphed (unlike SNB’s CHF move) that a disruptive move was avoided.  With the CNB likely to be the first in Europe to hike rates, we think the koruna will continue gaining.  EUR/CZK is on track to test the October 2013 low near 25.4840, which was right before the floor was instituted.  A break of the 25.90 area is needed to set up a test of the September 2012 low near 24.28.

Czech equities are still underperforming in EM after an awful 2016.  In 2016, MSCI Czech sank -7% vs. +7% for MSCI EM.  So far this year, MSCI Czech is up 1% YTD and compares to 25% YTD for MSCI EM.  This underperformance should ebb, as our EM Equity model has Czech Republic at a VERY OVERWEIGHT position.

Czech bonds have underperformed.  The yield on 10-year local currency government bonds is about +59 bp YTD.  This is behind only the worst performer China (+62 bp).  With inflation likely to remain high and the central bank starting its tightening cycle, we think Czech bonds will continue underperforming.

Our own sovereign ratings model shows the Czech Republic’s implied rating steady at AA-/Aa3/AA-.  As such, we still see upgrade potential for its A1 and A+ ratings from Moody’s and Fitch, respectively.  S&P’s AA- rating appears to be on target.