Last week, the Czech central bank announced that it was dropping the peg for the Czech koruna and the euro.
The announcement of the de-peg signaled the fact that the threat of deflation, which was engulfed the eurozone for the past few years was a thing of the past and that the region is now likely to look ahead to a normalization in monetary policy.
Czech central bank abandons 4-year peg
The Czech national bank introduced a target rate of 27 koruna to the euro back in November 2013. The measures were adopted at a time when recovery was weak, and the threat of deflation was real. The EURCZK peg was introduced to boost inflation and to ensure that the local currency did not strengthen against the euro.
The effects of the monetary policy via the peg were put in place to ensure that imports of goods and services were lower.
It was also designed to ensure that the fixed exchange rate would support the economy activity by making sure that Czech produced goods and services were more competitive in the global markets.
The Czech national bank introduced the peg at a time when deflation risks were the strongest as the eurozone economy continued to worsen coming out from the sovereign debt and the banking crisis. The eurozone economy was seen to be the biggest trading partner for the Czech Republic.
Markets a bit surprised but volatility contained
The timing of the Czech national bank to announce the currency de-peg was well managed. But the central bank announced at the March 30 monetary policy meeting that the “end date” for the EURCZK peg was fast approaching.
The only surprise was that the central bank did not give any specific date for the EURCZK de-peg. Market participants were expecting that the central bank would announce the EURCZK de-peg during one of its upcoming monetary policy meetings, with some expecting this to occur on May 4th when the central bank was scheduled to meet next.
Policy makers held an extraordinary meeting last Thursday, April 6th 2017 announcing the EURCZK de-peg.
At the meeting, central bank officials said that the exchange rate for EURCZK would now be determined by the supply and demand in the foreign exchange markets, but noted that it would still use its policy tools in order to mitigate any potential speculative fluctuations in the exchange rate if needed.
Following the announcement from the central bank, the Czech koruna posted a strong rally against the euro immediately, closing the day 1.54% lower.
Despite the announcement, some market watchers said that the central bank remained active in the forex markets.
Recent economic data suggested an overall improvement. The Czech Republic’s annual inflation rate surged to 2.6% in February, compared to a fragile 0.5% registered a year before. Since then, speculation has been mounting that the central bank would sooner or later abandon the currency de-peg.
Investors who bet on a strong appreciation in the Czech koruna against the euro were a tad disappointed with the rather soft response. By announcing the news first, central bank officials managed to limit the gains in the koruna.
The management of the currency de-peg was in stark contrast to that from the Swiss National Bank, which also abandoned the Swiss franc peg to the euro back in January 2015 [See Infographics].
— Holger Zschaepitz (@Schuldensuehner) April 10, 2017
However, back then the announcement took the markets by surprise in what is dubbed that the “Swiss shock” among other names. The incident cost the SNB close to 23 billion Swiss francs on paper, but the central bank managed to recoup almost all of its losses.
Following the CNB’s announcement, government bonds with shorter maturity sold off on expectations that tighter monetary policy will follow. Yields on the Czech krouna denominated bonds for October 2019 maturity rose to 0.93 basis points, which was the highest in 6-months.