Turmoil In Emerging Markets: The Czech Republic

Although the currency war has followed in depth the major players over the last few years, emerging markets are under substantial pressure to perform.  Loose monetary policies fed much of the gains witnessed in emerging markets as foreign direct investment dominated the investment scene, chasing after higher yields available in less developed markets.  However, now that the Federal Reserve has slowly backed away from further monetary stimulus and moreover is contemplating an interest rate hike, the acceleration in the pace of outflows from emerging markets might spell substantial more downside for emerging market currencies, notably the Czech Koruna. 

The Fundamental Picture

The Czech Republic has experienced blockbuster growth over the past few years as an influx of investment chasing after unrivaled GDP expansion sent the economy soaring.  After the economy double-dipped into recessionary territory following the bounce in the wake of the financial crisis, the economy has largely turned around since those darker days, staging a rebound since bottoming in 2013.  The Czech Republic currently boasts annualized GDP growth of 4.40%, well beyond comparable metrics available from European Union peers.  However, despite the optimistic headline numbers, not everyone in the economy has benefited from the rapid rise in fortunes over the past few years. 

While economic activity and expansion remain strong, especially considering the extraordinary accommodative measures taken by the Czech National Bank, much has been made of the fact that European Union membership has not caused a substantial uptick in wages and salaries which still trail behind many European peers.  With interest rates at 0.05%, matching the European Central Bank, inexpensive wages and prices have enabled the Czech economy to remain competitive in the current export trade paradigm.  With policies anticipated to persist, especially with inflationary measures tumbling, “lower for longer” is the clear outlook for policymakers as they struggle to fix imbalances. 

There is limited scope for a change in course owing to the global economic picture, but the prevailing outflows from emerging markets are not necessarily hurting the Czech Republic in the short-term.  Benefiting from the relative stability of the outlook coupled with low levels of government debt-to-GDP, the country is poised for further growth if the currency remains weak.  However, the problem with keeping a currency artificially weak through monetary policies is that the net benefit derived is not permanent, especially with other, larger central banks expected to increase their own participation in the global currency war and race to devalue. 

The one positive for the outlook is the nearing interest rate decision from the US Federal Reserve.  This decision has the propensity to drive the dollar higher against peers, especially emerging market currencies as investors flock to the relative safety of the currency in lieu of other risk assets.  Although September is not guaranteed as the time for interest rate liftoff, the decision to raise rates could easily push the USDCZK currency pair back towards the highs reached back in March after the currency pulled back following a substantial weakening in the Koruna experienced over the past year.

The Technical Take

Although the most recent moves in the USDCZK pair resemble a technical retrace after a prevailing longer-term uptrend begun in 2011.  The most recent leg which began last summer amid expectations of the Federal Reserve changing course saw a meteoric rise in the pair which is now retreating from multi-year highs.  A retrace of between 30-60% of the move begun in 2014 might be in play for the near-future until the outlook for September becomes clearer.  On a more medium-to-short term basis, the USDCZK pair is in the process of a triangle consolidation between support at 23.8383 and a near-term downtrend line, forming a descending triangle pattern on the 1-day candle chart.  This predominantly bearish pattern could be indicative of a breakout trade especially if prices fall below the critical support level.  This would pave the way towards further momentum downwards.

 

On a shorter term basis, namely the 4-hour candle chart, the USDCZK is the final stages of completion of a head and shoulders bearish formation which also has a bias to the downside, adding to the case for the pair to retest support at 23.8383.  The bottom of the pattern sitting at 24.1717 is the key level to watch because a break of this level would indicate increased potential for prices to run to the downside in the near-term.  However, the risk factors preventing this possibility is an uptick in US economic data in the near-term which sees the US dollar rebound from recent softness.

The Strategy

With no immediate perceived changes to the fundamental outlook and the technical setups screaming the potential for further downside, the ideal strategy for taking advantage of the recent softness in the US dollar along with the technical retrace of the pair is Put positions initiated near the prevailing multi-month downtrend line.  Should prices move above the trendline it could signal a potential reversal and moreover another run at recent highs in the pair, necessitating a Call position.  However, considering the current picture, the bias is skewed to the downside with Put positions ideally targeting 23.0000 over the short-term.