Why the Czechxit trade is not for the faint hearted

The Czech Koruna is on our radar right now as the market waits to see when the Czech National Bank (CNB) will drop the peg to the euro, which has been in place since 2013. The central bank met last week and disbanded with its previous guidance that it will drop the EUR/CZK peg, which stands at 27, in mid-year. It has not committed to maintain the peg beyond April 1^st, so now we are in wait-and-see-mode: we know that the end of the EUR/CZK peg is coming, we just don’t know when.

Why the CNB wants to drop the peg

The peg was first installed in 2013 to reduce the threat of deflation to the Czech economy. However, with inflation at 2.5%, its highest level since 2012, the peg is not only unnecessary, but it is now a threat to the economy. If the CNB had a stronger currency then this could dampen some of the inflationary pressure, which would make the CNB’s life much easier.

The trouble for the CNB is that it is tricky to unwind a currency regime. When the Bank first suggested that it would do away with the euro peg back in late 2016, it said that it wanted to avoid a Swiss-style surprise. However, after disbanding with its guidance that it would drop the peg in June/ July, and failing to provide another roadmap for Czechxit, it may be forced to surprise the market in the coming weeks.

Could the CZK become the most interesting currency in FX?

Speculation about when the peg will be disbanded has caused volatility in EUR/CZK to spike, the 1-week to 1-month volatility price has surged, suggesting that currency options traders are expecting greater price movement in that period, a sign that the market may be be looking for the CNB to drop the peg in the next couple of weeks.

Without a roadmap from the central bank on when and how it will end its peg, volatility is likely to remain elevated in the short-term.

Why the ‘CZK peg trade’ isn’t a one-way bet

An estimated $65bn of speculative capital has poured into CZK assets as the market is positioned for a strengthening of the koruna once the peg is dropped. This huge influx of speculative interest has caused increased levels of nervousness, hence the unwinding of some of these positions after the central bank held back from dropping the peg last week, causing the koruna to fall by the most in two years.

Although there has been a build-up of long CZK positions in anticipation of the change to the currency regime, any upward pressure may only last for the short-term. Once we have confirmation that the peg has been dropped then we evaporate, leading to a closing out of long CZK, and a hefty decline.

Where do we go from here?

Last week’s volatility in EUR/CZK was costly for the CNB, who is estimated to have bought EUR 3.7bn to supress the CZK, which was the most intense period of activity since the exchange rate regime came into place. As suspense around the koruna builds, and the cost of maintaining the peg rises, this could put pressure on the CNB to drop the peg sooner rather than later.

The next CNB meeting is on the 4^th May, if the options market is correct then the CNB may choose to drop the peg ahead of this meeting, so those with positions in the CZK need to be aware that the peg could also be dropped during an unscheduled meeting. As we mentioned, the Czechxit trade is not for the faint-hearted, and we expect volatility to remain elevated for this pair in the coming days and weeks.