FX and Rates Markets: Analyzing Scenarios for the Czech Koruna and CNB's Cutting Cycle

What to expect in FX and rates markets

The Czech koruna has been in a narrow range of 24.60-70 EUR/CZK for the past two weeks, which we believe is still an acceptable level for the CNB to start a cutting cycle. The current level of market rates indicates slightly stronger levels below 24.60. Thus, if global conditions allow, the koruna could still strengthen by next week's meeting. However, if the CNB delivers a rate cut, we see room to price in more cuts in the future, which would push EUR/CZK into the 24.80-25.00 range, based on the current strong relationship between the CZK and market rates. On the other hand, if the CNB does not deliver a rate cut, we believe the central bank has little to offer on the hawkish side, given that a cut seems inevitable. Thus, in response, the koruna may strengthen below 24.50; however, we do not expect it to stay there for longer.

The market is currently pricing in a rate cut of more than 30bps for the November meeting, indicating a strong dovish bias in the market, and also about 25bps for a rate cut in December. Looking ahead, the market may be overestimating the size of the rate cut in 1Q next year, but generally speaking, we see expectations for the year ahead as fairly priced. However, looking forward, the CZK IRS curve, in our view, shows a significant underestimation of the CNB's cutting cycle. Specifically at the long end of the curve, we think the 10y has the potential to trade 100bps lower and at the moment this is probably the biggest mispricing in the CEE space. However, the condition here is the start of a CNB cutting cycle and also a noticeable drop in core rates, which seem unlikely to be met for a while. Thus, the most interesting segment is probably 1-3y, which can still be influenced by the CNB itself and we see room for more rate cuts to be priced in here.

In bond space, our view has remained unchanged for a long time. This year's issuance is almost covered, plus the state budget has been surprising on the positive side in recent months. Thus, the supply of CZGBs is starting to decline, and MinFin is pre-funding next year, which already indicates a significant decline in borrowing needs and supply of CZGBs. Together with the start of the cutting cycle, we thus see CZGBs as cheap in ASW and also relative to CEE peers at the moment.