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Tuesday 19 March 2024

For many, the default position has been to assume that the US consumer is in a position of strength: the labour market looks strong, wages are increasing and there is therefore potentially sustained pent-up demand from the pandemic. But are we taking the strength of the consumer for granted?

At first glance (and simply as food for thought), the chart below – which shows that consumer credit in the US is increasing at the fastest pace in recent years – is perhaps an indication of an economic rebound. However, it got me pondering: do people access credit when they’re feeling rich or when they’re feeling poor? So is this subsequently a sign of economic strength or weakness?

There’s a seasonal pattern to consumer credit (which includes credit extended to individuals, via credit card loans) which is to be expected: the pace of consumer spending tends to peak in November / December, given the lead up to big-spend events like Thanksgiving and Christmas, the following quarter (January through until March) then usually sees a decline in credit balances and the overall pace, as consumers ease off spending. As such, the Q4 spending peak is not typically matched or exceeded until much later in the following year. You can see some of this at play in the cumulative data chart below; it’s not unusual to see consumer credit increase by $50bn or more in the final quarter of the year, but it is unusual to see this in the first quarter. However, that’s just what’s happened this year. The current 2022 cycle has broken with the previous trend, as the pace of consumer credit growth quickly exceeded $50bn at the end of February and soared through $100bn at the end of March – a level that’s not usually reached until May/June. 

Source: M&G, Bloomberg, 31 March 2022

So is this a sign of consumer strength or weakness?I can see the argument both ways. Clearly this behaviour is fuelled by both consumer demand and higher inflation, but which is dominating?

If this trend is fuelled from a position of strength, you can see how consumers may be in good shape and “feeling rich”. With unemployment at its lows, workers arguably have a steady stream of income and therefore the confidence to service their credit card debt and bring forward future purchases. Happy days, nothing to see here.

However, the “bringing forward future purchases” argument is also textbook rationale for how consumers react when faced with inflation. Given the inflationary environment (which we expect to remain for some time, as we blogged about here), the same level of consumption now requires a greater nominal spend – bringing forward purchases is therefore behaviour that’s very much consistent with rising price levels: buy now, while it’s cheaper. Especially if these purchases are staples.

As such, the chart potentially indicates that this is a sign of consumer releveraging, and that instead of this being a healthy sign, it is very possible that excess savings have been worked through and credit cards are stepping in to help fuel current consumption. This is a view that was aired by RBC. When similarly contemplating the plight of the consumer, RBC note that low-income US consumers are at risk right now, having overspent and having used up the vast majority of the fiscal stimulus that was provided to them during the pandemic. Goods spending is significantly above a pre-Covid baseline and the bottom half of the wealth spectrum are spending a greater amount on the basics (i.e. gasoline, food and rent) given inflation.

At the other end of the spectrum, there is similar concern about the more affluent consumers as, although it appears that they are sitting on a large amount of cash, it is not expected that this cash will find its way into consumption. Equity markets are down, so there has been a negative wealth effect for the upper income cohorts and Quantitative Tightening may not help this. 

Source: RBC, Federal Reserve Board/Haver Analytics, 31 December 2021

Having these charts pop up on my radar, I’ve realised that it’s not just a US story. Consumer confidence in the UK has also fallen markedly in recent months.

Source: HSBC research, Bloomberg, GfK, 30 April 2022

Although balance sheets can still be characterised as healthy,inflation can and present a challenge to this, ultimately leading to demand destruction. Although the current quarter is likely to be robust as consumer spending on services kicks in, the second half of the year may be one to watch, serving as a stark reminder that the strength of the US consumer should not be taken for granted. 

This week’s Budget and Bank of England meetings may shed some light on a key question for investors and millions of taxpayers: After eight years of fiscal tightening, is austerity over and will the economic burden shift from monetary to fiscal policy? I wouldn’t hold my breath – something which may cheer gilt investors, at least for now. Let’s see why:

In her recent Conservative Party conference speech, Prime Minister Theresa May suggested that the UK is nearing the end of austerity, leading to certain spending optimism ahead of this year’s Budget. After all, Chancellor Philip Hammond does have a few things in his favour: higher receipts and lower expenditure this fiscal year means that government borrowing is expected to come in approximately £5-6bn lower than the Spring Statement forecast in March (which is likely to be met by reduced gilt issuance – more on this later). The consensus also expects borrowing to fall further in the next fiscal year, which could return the UK to pre-2007-08 crisis levels.

Though this all sounds positive, a recent Institute for Fiscal Studies (IFS) Green Budget conference painted a less rosy picture, especially with regards to UK public sector net debt, which is still high despite it falling slowly. Debt is still higher than pre-crisis levels and with growth expected to remain sluggish (forecasts are of 1.5% per year from 2017-23, compared to a pre-crisis average of 2.7%), the UK’s debt to GDP ratio will remain elevated.

Despite the Chancellor’s savings, the high level of debt (currently approximately 85% of GDP) is still a concern, as this reduces the fiscal wiggle-room in the event of a downturn. In the chart below, the IFS shows the implications for debt going forward: maintaining a deficit of 1.8% of national income would see public sector net debt fall so slowly over time that even by 2040, it would still be above 70% of national income. Eliminating the deficit entirely would see this fall faster, but is this a realistic scenario? For a start, both scenarios assume growth will be smooth.

A closer look depicts an even gloomier scenario: as seen in the second chart, factoring in the impact of recessions, the IFS finds that even if the Government eliminate the deficit, from 2021-2066 debt as a % of national income will still exceed 2010 levels in each scenario.

Eliminating the deficit in itself remains a challenge, but there are additional reasons to be bearish. The Government has made pre-commitments of lifting the public sector pay cap and an additional £20bn in spending on the NHS will cost up to 1% of GDP by 2022/23. Where’s the funding going to come from? Cue the Autumn budget. However, given the Conservative Party’s manifesto to rule out any changes to the rate of VAT, income tax or national insurance (which equates to approximately of 60% tax revenues), it really is unclear to me how the UK can reduce debt.

I tend to think about the economy in terms of the components of aggregate demand (i.e. consumption, investment, government and net exports). I’ve been wary about consumers being able to prop up the UK economy (the savings rate is at multi-year lows, plus the strain on real wage growth is a concern) and business investment sits under a cloud of trade-links uncertainty. On the net exports front, the UK has seen a boost to exports from the currency depreciation, but imports remain elevated as it takes time for the substitution effect to kick in. As if I didn’t have enough reasons to be bearish on the UK economy (and I have intentionally avoided the topic of Brexit uncertainty!), the state of the government finances doesn’t fill me with much glee either.

What are the implications for UK government bonds? The reduction in borrowing (and therefore issuance) this year should be beneficial for gilt investors, but the degree of uncertainty regarding how the government will fund the extra planned spending may throw a spanner in the works. Any downwards revisions to borrowing in future years would reduce gilt supply and mostly likely lead to a knee-jerk reaction, with gilts rallying. This, however, might be short lived, as – to my mind – politics, not economics, is likely to remain the bigger driving force of yields in the near term.

If you looked at the post-referendum changes in sterling versus the dollar, or the movement in gilts, you’d be forgiven for thinking that Brexit was done and dusted. The 10 year gilt yield has bounced back to around pre-referendum levels hovering around the 1.4% mark (in August 2016, 10 year gilts rallied to historical lows of 0.5%), while the front end of the yield curve has moved higher. Similarly, from a currency perspective, GBP real effective exchange rates have bounced considerably from their post-referendum lows.

On the surface, this perhaps suggests that Brexit concerns have abated. Indeed, up until last month, the market was pricing over a 90% probability of a rate hike at tomorrow’s meeting (which would be the first time rates have been above 0.5% since March 2009). Scratch a little deeper however and there are still signs that there’s a raincloud hanging over the UK, which is why the Bank of England (BoE) may pause tomorrow, explaining why the market’s rate hike expectations have fallen off a cliff.

Initially economists and the market priced in a doom and gloom Brexit scenario, but after the currency depreciation and big gilt curve moves, the economic data held up into the end of 2016. As the political discussions have dragged on with definite details sparse, ‘Brexit boredom’ has perhaps been the result. Through 2017, front end gilts traded sideways in a 40 basis points range, with this range limited to just 15 basis points from September (the market priced in a reversal of the BoE’s post-referendum ‘emergency’ rate cut, which was indeed reversed in November) through to the year end.

For the best part of this year, with rate hike expectations growing, it has paid to be short duration in the front end. But the trajectory has recently changed. Just as the market had decided to underweight the politics and the gilt curve had become sensitive to central bank rhetoric once again, more of the economic hard data has started to turn. The near-certainty of a May rate hike was first called into question, when during an April interview with the BBC, Mark Carney explicitly stated that he was “conscious that there are other meetings over the course of this year.” Since this warning, the economic data has followed suit. CPI at 2.5%, retail sales of -1.2% and Q1 GDP at 0.1% have all been below expectations. Last week, in the final run up to this week’s meeting, all of the UK’s PMIs (manufacturing, services and composite) fell below expectations.

If the May hike is off the table, then when do the BoE move next? Central banks remain data dependent, but are increasingly intent on hand-holding, providing signals and guidance to the market. What this has meant in recent practice is that both the FOMC and BoE have tended to move rates at meetings which are followed by press conferences, where they can verbally articulate their changes. This is why the market is pricing in a low probability of a move by the BoE in June, but a greater chance of a hike at the quarterly meeting in August. To my mind, even August may prove too soon, if the consumer squeeze and hesitant investment environment continues.

Brexit uncertainly is still an issue. It’s very much on the political radar and is on the economic map now too; the market had just been temporarily lulled into a false sense of security. Without supportive economic data or political clarity, any move upwards in rates could easily prove to be a ‘bad’ hike.

Richard recently wrote about how government bond indices should be adjusted to account for quantitative easing (QE) purchases, thereby better reflecting the actual availability of investments in the market. A key argument indicated that given the absence of this adjustment, European government indices are incorrectly skewed towards more highly rated sovereigns, even though their issuance is not freely available to purchase.

I have expanded on this work to assess this idea on a global scale using the ICE Bank of America Merrill Lynch Global Government Bond index (i.e. reweighting the index to adjust for the QE undertaken in Europe, the US, UK and Japan). Though the premise remains the same – i.e. that bond indices should look different in a QE adjusted world –  the impact at the global level differs from the European analysis in two key ways.

  1. Adjusting for large QE programs does not necessarily mean that the country’s weight in the bond index falls

Broadly speaking, I had anticipated that countries which had undergone QE would see their weights in the index reduced, while other country weights (i.e. those which did not do QE) would rise. Looking at the table below, though this was indeed the case for countries where central banks continue to undertake wide-scale QE (e.g. Japan, Germany, Sweden) or where this has been conducted previously (e.g. in the UK, most recently after the EU referendum), I did not expect the change at the top of the table where the US has increased its weight by 3.33%.

Though the US has itself completed $2.5tn worth of government bond QE, this is dwarfed by the ¥400tn (approx. $3.5tn as at 20th October) worth of ongoing QE conducted by the Bank of Japan. Adjusting the index for the free-float of government bonds, Japan – the second largest weight in the index, but the country with the largest QE program –  sees its available investment universe fall considerably and hence its index share is reduced from 27% to 20%. On the other hand, though the US investment universe has also decreased, its outstanding issuance remains large.  As a result, the US manages to retain its proportional top spot in the index, increasing its weight from 36% to 39%.

  1. Adjusting for QE on a global scale would improve the credit quality of the index

In the previous European focused blog, we showed that adjusting for QE causes higher rated countries like Germany to lose weighting in the index to lower rated countries such as Italy and France. This trend does persist at the global level, but the aforementioned reduction in Japanese holdings has a secondary meaningful impact. Since Japanese government bonds are rated A, the reweighting away from this country towards others such as the US, Australia, Canada which are more highly rated, means that the overall index actually improves in credit quality (67% rated AAA or AA, compared to 62% previously). This is in contrast to the European index where the credit quality deteriorates.

This analysis has interesting practical implications. We argued previously that tracker funds, following European indices that are not QE adjusted, are potentially driving up European government bond prices (i.e. being forced buyers in an environment with reduced free-floats). Although the same case could be made for Japanese government bonds, US Treasuries are arguably under bought.

While the market gears up for the much anticipated European Central Bank meeting on Thursday, there are two other European central banks due to meet earlier in the day; Sweden and Norway.

I was in Washington a couple of weeks ago for the World Bank and IMF conferences, which was a great opportunity to hear from policy makers and economists. It served as a timely reminder that the European central banks are likely to be more patient (i.e. dovish) than market participants expect – especially those with strong trading links to the Euro area. In the case of Sweden, it has taken 6 years for growth to pick up and maintain a convincing upward trend, inflation and expectations also. Policymakers will not be in a rush to tackle rising inflation prematurely.

There’s been much speculation about whether the ECB will tweak or begin preparations to exit its quantitative easing (QE) programme. The Swedish Riksbank has been implementing its own quantitative easing and although the economic fundamentals in Sweden have been improving, indicating for much of this year that normalisation is perhaps warranted, I do not anticipate this being tweaked ahead of the ECB announcement. This is because what’s especially pertinent for Scandinavian nations – particularly Sweden, Norway and Denmark – is that as small open economies with large shares of GDP derived from trade, it is the exchange rate which acts as the key transmission mechanism for monetary policy (Denmark with its currency peg, is obviously more explicit about this).

Given that both Sweden and Norway have strong economic links to their Eurozone trading partner, neither the Swedish Riksbank nor the Norges Bank would want to see their respective currencies appreciate (and their inflation target missed) by implementing hawkish monetary policy. This would only serve as a first-mover disadvantage. They too, will be in wait-and-see mode on Thursday with respect to the ECB, before they embark on their own policy normalisation path.

The final point worthy of note is with respect to leverage in the housing sector. The chart below shows how this is a growing problem, not just in Scandinavia, but in countries such as Canada and Australia too. It is difficult to find research which doesn’t cite this as a growing problem in these economies, often pairing this reasoning with arguments why central bankers will not be able to hike rates significantly. Scandinavia essentially needs two interest rates; one (which is much, much higher) to curb the housing market and a second one (to remain low) for corporates to ensure they remain competitive versus the continent.

Since the meetings in Washington however, I have noticed just how many central bankers worldwide have been at pains to stress that financial stability is not their key remit. Household debt is on their radar but it’s a problem for macro-prudential tools or politicians to deal with and not traditional monetary policy. The ball is being shifted to someone else’s court. If and when the Scandinavian central bankers do embark upon their rate hiking cycles, it will not be housing sector concerns that stop them from doing so. Market participants would do well to remember that central bankers may be agnostic towards housing market excesses when the tightening cycles ensue.

Another month has drawn to an end, which presents a good opportunity to take stock and review recent events and Bloomberg’s surprise monitors – true to their name – have provided some unexpected results in August.

1) UK: back in the green, surprising to the upside once again

Economic analysts appear to have been too pessimistic in August, suggesting that perhaps too much doom and gloom has been priced into the UK rates market.

Given the Brexit backdrop, I’ve been pessimistic on the economic outlook for the UK, which is in-line with many economists’ thinking (in fact, since the EU Referendum, I’ve not met with a single research house that is bullish or in the least bit optimistic). Although the economic data for the UK held up well into the 2016 year end, this has since rolled over with consumer readings a particular concern. Earnings growth remains subdued, retail sales are trending downwards and the YouGov/Cebr consumer confidence survey recently indicated that consumer perceptions of household finances deteriorated for the fifth consecutive month (the longest negative trend since records began 8 years ago).

Despite these outcomes, the ingrained low expectations mean that the UK economic data has managed to outperform the low base of expectations. Bloomberg’s surprise indices monitor economic analysts’ expectations and indicate where the underlying business cycle under or overshoots their forecasts. As you can see below, many sectors – particularly the labour market – surprised to the upside in August.

What’s interesting is the effect that this has had on the overall index, where the aggregate UK surprise index moved back into the green in August. This indicates that the economy has outperformed economist expectations, after a run of data surprises to the downside since April of this year. If this trend continues with economic forecasts continuing to underestimate the UK, we could see rates sell off on individual data releases, as market participants start to price in the surprisingly robust fundamentals.

2) Euro Area: the surprisingly positive trend continues

In contrast to the UK, Europe has exhibited an upward trend of positive data surprises over the same time period (i.e. post the EU referendum), with the retail sector and business surveys the main drivers of late. The consistency in positive surprises indicates that economists have perhaps been too cautious in forecasting the Euro area recovery, in line with Draghi’s careful dovish messaging. After this strong run of data releases, if economists were to turn more bullish from here, I would expect to see core Euro area rates sell off, reflecting the improvement in the underlying economy and expectation of more imminent policy normalisation from the ECB.

3) US: Consistently surprising to the downside since the last hike

What’s surprising about the US, is that since the FOMC’s last rate hike in mid-June, the data from the underlying economy has constantly undershot analysts’ bullish forecasts. This is in contrast to the previous two hikes in December 2016 and March 2017 where data continued to surprise to the upside for months afterwards. That’s not to say that the underlying economy is slowing down (Q2 GDP was revised up from 2.6% to 3% at the end of August, driven by solid momentum in domestic demand with both the consumption and investment contributions increasing. Retail sales also surprised to the upside etc.), but rather that analysts have been supremely optimistic on the data front.

What’s clear from these charts is that most recently, economists have been too bearish on the UK and Euro area, but too bullish on the US. This does not bode particularly well for those advocating an aggressive rate hiking path from the FOMC. Indeed, the underwhelming data in the US has been reflected in market expectations for Fed rate hikes, with 60 basis points of rate hikes priced out from the Fed Funds curve (over the next 3 years). The pessimistic view on the Euro area, however, arguably makes it a tad easier for the ECB to follow its slow and gentle plan towards policy normalisation, as forecasters are similarly reticent about being too bullish too soon. In the UK, this has made me ponder the Bank of England’s policy rate. The “emergency rate cut” of August 2016 to 0.25% could be reversed should this trend continue (there already are a couple of hawks in the MPC), though this is certainly not what most economists are expecting.

Despite US rate hikes in December, March and another last week, the US dollar has depreciated back to pre-election levels.  All of the Trumpflation dollar premium has disappeared.  As the Trump dollar trade appears to have run out of steam, the Euro has however been climbing. Optimism around the Euro area growth comeback grew leading up to the ECB meeting earlier this month, with EUR/USD hitting an 8-month high at 1.13, despite Draghi delivering a decidedly dovish statement (with many now questioning their assumed timelines for policy normalisation via tapering and eventual rate hikes).

What’s been interesting about these recent currency moves is that the relative outperformance of the euro has not been driven by rising interest rate expectations for the euro zone’s currency bloc relative to rates in the US.  In fact the opposite has been happening.  The two charts below show that the recent trend has been for US rate expectations to be stable or rising compared with its major trading partners, and yet the dollar has underperformed sharply despite this rate divergence.

So if rate differentials aren’t driving the dollar and the euro at the moment, what is?  Firstly the Citi FX positioning survey suggests that whilst investors had been heavily overweight the US dollar and underweight the euro in 2016, there has been a reversal in this positioning.  A large short position amongst investors and speculators can cause significant upwards price corrections on relatively small changes in fundamental outlook, as short covering takes place.

Perhaps most importantly, the fundamental valuation of the euro has also supported its rally.  Looking at Purchasing Power Parity (PPP), the euro looks to be almost 20% “cheap” to its fundamental value against the US dollar.  Now that the economic data has started to come in stronger, and ahead of expectations in the euro area, and the political uncertainty surrounding elections in France, the Netherlands and elsewhere has diminished substantially, this big undervaluation has suddenly been noticed.

The Czech National Bank (CNB) has removed its cap against the Euro, which I blogged about earlier this year. Though the signs had been pointing to an early removal (headline inflation had been within the target range since October last year and the CNB had hardened its signalling language), the timing of yesterday’s move at the central bank’s extraordinary meeting did come as a surprise. Currency appreciation post the event has been fairly muted, with the CZK rallying 1.5% against EUR on the day.

The CNB is likely breathing a sigh of relief; the Czech Republic is an export orientated economy and thus excessive appreciation would hamper this somewhat. But where does it go from here? As I mentioned in my previous blog, when the cap was in force, the CNB would not permit appreciation beyond the level at which they intervened; approx. EURCZK 25.7 (the market closed at EURCZK 26.6), so this is perhaps a reasonable expectation regarding the appreciation ceiling.

The rates space is also interesting. The removal of the cap is a monetary tightening, with CNB governor highlighting in his press conference that “ending the cap was the first step toward gradual policy tightening”. With the market pricing in the expectation of this, the sell-off in the Czech sovereign bond curve (alongside the currency appreciation) is perhaps now pricing in more of a tightening that the CNB should have liked.

If the CNB monetary tightening is to be a gradual measured response, instead of the bear steepening that the market may be assuming, this now becomes appealing from a relative value perspective – see the graph below – but also on a currency hedged basis.

The final aspect to bear in mind is that Czech bonds will be held in the main bond benchmark indices from the end of this month. CZGBs will be included in the GBI-Emerging Market index on 28th April with a weight of 3.3%. This will create demand for the bonds for those using this index as their passive or active benchmark which will put some small appreciation pressure on the currency. Bigger moves could however occur in the opposite direction and the currency could of course depreciate from here, should the large speculative investor flows (estimated at $65bn) anticipating the removal of the cap now dissipate, which would lighten the CNB’s workload somewhat.

In maintaining the currency cap, the CNB accumulated €47.8bn of reserves which, according to its website, it will continue to invest in “high quality, safe instruments” and “will not sell the returns on those reserves for the foreseeable future”. There will be further interesting times ahead for the CNB who – either way – stand ready to intervene against extreme exchange rate fluctuations.

Yields on Canadian sovereign bonds have been dragged higher in recent months, with the yield on the 10-year bond recently reaching 2 year highs. This sell-off appears to reflect the US reflation narrative, rather than the economic fundamentals of the Canadian economy.

The market currently thinks the Bank of Canada will remain on hold throughout 2017, pricing in only one rate hike – a 20 basis point move – in 2018. The stance of the BoC, much like the ECB, BoE and BoJ appears increasingly at odds with the outlook for US monetary policy.

Unlike the US however, with the unemployment rate at 6.9%, this remains elevated compared to the pre-crisis years and the BoC continues to highlight the level of slack which remains in the labour market. Although headline inflation has picked up in recent months, this was downplayed by the BoC at its latest meeting, with wage growth remaining sluggish and aggregate hours worked weak.

Though the market is leaning towards pricing in a rate hike, there are a few key downside risks to this view.

Firstly, oil. The fall in the oil price detracted from Canada’s GDP growth in both 2015 and 2016 and the recent leg lower could potentially provide an ongoing headwind. Hearteningly, analysis from RBC suggests that oil is less of a concern today insofar that the price would have to drop below $25 before companies started to shut their operations. However, a price above $70 would be required for brownfield investment and above $100 for any significant greenfield investment – a significant hurdle.

Secondly, the strength of the domestic economy is an obvious concern for policymakers. The aforementioned labour market slack alongside disappointing non-energy export and lacklustre investment growth remains an area to watch (though the previous $11bn of fiscal expansion in infrastructure spending has fallen rather flat, as take up for funding new projects has been disappointing). Other noteworthy factors include a housing market where prices continue to surge nationally (particularly in Toronto) and the increasing indebtedness of consumers (as RBC pointed out, non-mortgage credit market debt to personal disposable income ratio reached a new high of 167.3% in Q4).

Finally, and perhaps most significantly, U.S. economic policy will have a significant impact on the Canadian economy. If trade tensions heighten, or the U.S. were to implement or make inroads with respect to a border adjustment tax to fund consumer tax cuts, the terms of trade shock could detrimentally affect the Canadian outlook. On the other hand, the U.S. administration’s fiscal plans remain unclear, and any fiscal boost to the U.S. economy could have a positive spill over effect on the Canadian economy.

As it stands, it is difficult to argue with implied market rates – Canadian monetary policy will likely remain stagnant, creating a larger gulf between US and Canadian policy. Over the longer term however, risks to the downside for the Canadian economy are not yet dissipating, so it’s just as likely that the next move in interest rates could be a cut. As such, a bullish view on Canadian government bonds and a bearish view on the currency is perhaps warranted.

For over 3 years, the Czech National Bank (CNB) has maintained the Czech Koruna (CZK) exchange rate close to 27 CZK to the Euro (EUR), essentially using its currency – as opposed to interest rates – as the policy tool to achieve its inflation target. Earlier this month however, the CNB advised that this strategy would be exited “around the middle of 2017”. Though the timing remains ambiguous (they previously stated that the cap would be exited “in mid-2017”), the message is clear: the removal of the FX floor is looming and how the market responds will be of interest.

The EURCZK cap was first introduced in November 2013 after a short period of CZK appreciation. Since the Czech Republic is an export driven economy which is highly dependent on trade with countries in Europe (particularly Germany), the policy subsequently served as an effective way to weaken the currency, ensuring its competitiveness with its main trading partners whilst easing monetary conditions domestically. It’s regarded as a floor as the target is asymmetric; the CNB will not allow the currency to appreciate markedly from the aforementioned level, obliging them to intervene (i.e. by selling CZK and buying EUR) in the currency markets in order to maintain the strategy. Given this, CNB EUR reserves have more than doubled over the duration of the programme, with the size and frequency of interventions increasing in recent months as currency speculators have entered the market, upping the pressure on this managed floor.

The floor was introduced to ease monetary policy; the removal will be used to tighten it.

With an inflation target of 2% (plus or minus 1%), CPI had been outside of this range since early 2014. The October reading garnered attention however when it fell within the CNB’s tolerance band, which was sustained through November.  What was particularly surprising was that the 2% target was reached in December – something that the CNB wasn’t expecting to achieve until Q3 2017. On Friday CPI surprised to the upside once again, this time hitting 2.2%. The rise was largely due to higher food prices as well as base effects kicking in from the unwinding of the year-on-year fall in fuel prices. Encouragingly, core inflation (which excludes oil) also increased, while wages are expected to continue to remain on an upward trajectory.  This rise in domestically driven inflation, alongside an expectation of some externally imported inflation (the economic development of the Eurozone is significant, due to the trading links and thus the potential for spillovers from the growth in industrial producer prices) feels as though the previously high hurdle for the removal of the FX floor has been lowered. Cue the currency speculators.

Given the FX floor, the CZK has perhaps been kept artificially low, leading many to surmise that the removal of the floor will lead to significant currency appreciation. Speculators should however be mindful of three key points.

  • Negative rates. Given that interest rates are negative in the Czech Republic, this is a negative carry trade, which could potentially make holding the position quite painful – particularly if the CNB decide to extend the removal date. Nevertheless, the 6m forward points have moved significantly since January, indicating that positioning for CZK appreciation is becoming increasingly attractive.

  • The CNB’s reaction. This will be of considerable interest. Given that the Czech Republic is an economy dependent on its exports, the CNB would not want to damage its competitiveness and would surely intervene against any sustained appreciation. At the moment, the current CNB strategy states that they would not permit appreciation beyond the level at which they intervened (approx. EURCZK 25.7). If we assume this approach is upheld after the removal of the peg – which I think is credible –  this represents a 4.8% appreciation from the current FX floor at EURCZK 27, so there is definitely some potential upside in the trade.
  • Speculators may all rush for the door. The last point highlighted the potential appreciation from the removal of the FX floor, but what happens if lots of investors are positioned similarly and they all rush for the door, in order to lock in the profit? Those speculators long CKZ would want to sell and buy EUR to close the position. Lots of trades in the same direction however would cause the CZK to depreciate which would erode the gain on the trade (alongside the negative rates).

The inflation numbers from Friday exceeded expectation, which may further encourage buying of CZK, as investors anticipate the removal of the FX floor. However, I have struggled to find a forecast which predicts appreciation significantly in excess of the EURCZK 25.7 level discussed; which is perhaps testament to the credibility of the CNB. What will happen when they remove the floor? Time will tell.

Author: Anjulie Rusius

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