That prospect might come as some comfort to the Czech National Bank (CNB), which announced its first intervention in the FX market for 11 years on Thursday, saying it had decided to start using the exchange rate as an additional tool for easing monetary conditions.
The koruna dropped more than 3% against the euro, its biggest slide for over four years, after the CNB said it will intervene on the foreign exchange market to weaken the koruna so that EURCZK is close to Kc27.
The fact the CNB, faced with inflation well below its 2% target, entered the global currency wars should not come as a shock to investors.
Indeed, the koruna weakened last month when Miroslav Singer, the head of the CNB, revealed in an interview with Euromoney his support for intervention in the FX market to avoid Japanese-style deflation.
| Main Czech inflation measures (year-on-year) |
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However, the CNB’s chances of success could well be enhanced by the prospect of renewed strength in the dollar.
Indeed, while the dollar has taken a beating in recent months, a rebound could spell danger for many EM currencies.
The dollar index, which measures the currency’s progress against a basket of six leading currencies, has dropped by more than 6% since peaking in July. The prospect of a new Federal Reserve chairman, budget wrangling in Washington and softer US economic data all undermined the dollar, heightening expectations of a delay in the US central bank tapering its asset purchases.
However, Mitul Kotecha, global head of currency strategy at Crédit Agricole, believes the prospects for the dollar seem to be improving, amid signs the currency has discounted a lot of the bad news already.
He believes there are signs of a dollar turnaround coinciding with some bottoming out in 10-year Treasury yields around 2.5%.
“While it may still take some time for the dollar to establish a sustainable rally, it looks increasingly as though the downside risks to the currency are diminishing,” says Kotecha.
“The overall trajectory of the US economy is set to be more robust than other developed economies, while US yields remain on track to move higher relative to other core yields. All of this will support the dollar.”
The flipside to dollar weakness has been strength in EM currencies, with receding tapering fears offering them respite from the weakness witnessed earlier in the year.
Indeed, the three EM currencies that have strengthened the most since the dollar index began its descent in July have been the Czech koruna, Polish zloty and Korean won.
Kotecha does not believe that trend will continue. He forecasts renewed Fed tapering fears and a bottoming out of US Treasury yields will result in the dollar index strengthening by just over 3% by the end of 2013 and by a total of more than 8% by the end of 2014.
He says the EM currencies most at risk from a firmer dollar, which have the highest negative correlations with the dollar index, are all Central and Eastern European (CEE) currencies. As the chart below shows, it is the Hungarian forint, zloty and koruna that are the most sensitive to changes in the dollar.
| EM currency sensitivity to dollar gyrations |
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“The strong relationship between the dollar index and CEE currencies may reflect the fact that these currencies act as turbo euro currencies,” says Kotecha.
“A strengthening dollar index predominantly means a weaker euro, and its impact is magnified by CEE currencies.”
As the European Central Bank cuts rates and undermines its currency against the dollar, the CNB will be banking on the koruna asserting its “turbo euro” credentials.