Czech and Hungary Monetary Policy--Distant Cousins?

In one of last week’s post, I made some off-handed remarks about what makes a good macro trade, or in that case, what doesn't. Yes, you need a big picture view. You need complacency, stupidity, regulatory dislocation, misaligned incentives, or some combination, to generate the market mis-pricing necessary to score big when there is a catalyst to set the tinder ablaze.

Reading the newspaper over the weekend, I got thinking about the Czech Republic after the anti-establishment ANO party won big, putting their pseudo-Perot type figure Andrej Babis in line to be the next prime minister.

I thought the big story would be the large share of the vote won by anti-establishment candidates in this election and last week’s election in Austria. If you look at the type of candidates that are winning elections in Central Europe, it is consistent with the global trend towards liquidating the establishment, more so than necessarily far-left or far-right movements. Look at recent history: the United States, France, South Korea (sort of, by South Korean standards anyway), and Czech Republic have elected decidedly anti-establishment figures, while non-traditional and/or radical parties or candidates have done well in the UK, the Netherlands (Wilders and the Greens still gained seats at the expense of the establishment, even if not as many as predicted), Czech (again) and Germany.

Indeed this is the story of 2017, and will continue to be later this year and into 2018 when we will get potentially market moving elections in Mexico, Brazil, and Italy--with an election in Hungary already in the bag for their nationalist prime minister, Viktor Orban--who arguably kicked off this trend in EMEA back in 2010.

Yet after kicking the tires on Czech assets over the weekend, there doesn’t seem to be much stress about politics. The far bigger story this year has been the decision by the CNB to float the koruna, allowing it to appreciate versus the euro.  And as so often happens, the really juicy macro trade may be a layer beyond the current potential for policy tightening in the Czech Republic.

First, getting an award like this is always a little awkward. It is like winning coach of the year in the SEC West. Sure, great job...but come on...look at the neighborhood.

Yet the CNB is a strong, highly credible organization. Their chief economist hit the tape with this hatchet job on the rates market late last week:

Doesn’t get much more explicit than that. Listen to the game masters. This type of verbal intervention, or forward guidance if you prefer, has pressed rates and CZK higher. If rate hikes are coming, is there still more upside in CZK? The currency has continued to well over the last couple of months...note the break higher from high levels

And interestingly, duration has gotten pummeled. A big element here is that foreign investors piled into the country recently, and now are getting barbequed by rate hike expectations. CZK REER has only broken away from its CE peers since the break higher in rates over the past couple of months.

Yet the move in the currency is totally uninteresting when compared to the Teutonic juggernaut to the west:

That leads me to believe that unless there is some weird softness in the inflation data, the CNB will have to deliver on the rate hikes priced into the curve, which should continue to support CZK over the next few months.

Perhaps lost in the din is why CNB is tightening policy in the first place. Inflation!! I found it Margaret! But what is the first thing you notice in this chart? Hungary and Czech HICP have been pinned to each other for most of the past four years.

So we might expect the HNB to be following a similar course to the CNB? No, quite the opposite.

I have to admit, this is one of my favorite charts of the year. The 2y rates crossed only days before the CNB allowed the CZK to float and the two trends barely took a breath, despite inflation following in lockstep!    I’ll have to go a few more rounds in the EMEA ring to build out this idea, but that inflation chart and the cross in 2y HUF and CZK rates is what a breakdown in central bank credibility looks like.

We have some dry tinder here:

• higher inflation, 
• a very tight labor market, 
• a government that has to borrow tons of money every year to finance itself, and 
• inflows from the EU

Will that cause inflation expectations get out of hand in Hungary, leading to a panic among the notable number of foreign investors, and force the HNB to tighten policy, despite a questionable record of independence and a parliamentary election coming next year? 

For now I think the answer is still “no”, the prior REER charts don’t illustrate a big dislocation in competitiveness, and the chart below argues the currency side might be more of a “single” than a homer. But rates...yes….carry/risk vs. reward ratio could be very appealing.

Rates in Hungary should be higher. But nobody makes money on should. Will it actually happen? Place your bets, folks. Macro at its finest.  

Shawn
TeamMacroMan2@gmail.com
@EMInflationista