Czech Koruna Vs. Euro: A Potential Arbitrage Opportunity

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Includes: FXE
by: Discount Fountain

Summary

While deflation was a significant concern pertaining to koruna weakness, I expect that higher than expected GDP growth and rising oil prices will curb concerns in this regard.

I expect the Czech Koruna to move in lockstep with the Euro.

However, economic growth must keep pace with the Eurozone to prevent significant depreciation.

A potential arbitrage opportunity exists by going long EUR - short CZK.

Up till mid-January, the Czech Koruna was one of the worst performing currencies worldwide in 2015 - having fallen by over 5% against the US Dollar. While the koruna has appreciated by roughly 3% against the Euro since January, the currency has continued its sharp fall against the dollar, to the tune of approximately 8%.

Deflation has been a big driver of weakness in the Koruna, with the Czech Republic being forced to take active steps to weaken the currency to bolster inflation rates. While inflation in the country lies slightly above that of the Euro area at approximately 0.1 - 0.2%; the Czech central bank decided last month to keep interest rates at zero. Additionally, the central bank quoted that, "the Czech National Bank would not discontinue the use of the exchange rate as a monetary policy instrument before the second half of 2016."

Clearly, the Czech Republic has not been immune to deflationary pressures. In this regard, it has broadly weakened against the US dollar in line with the euro. Apart from the fact that the Czech Republic and the Eurozone use different currencies, there is not all that much to distinguish the two economies. Deflation remains a concern, and a zero interest rate policy is being used to bolster inflation. GDP growth for both economies this quarter ranged from 0.2 - 0.4%. However, with growth concerns in the United States and a rising euro - will the koruna rise in tandem with the euro or be left behind?

Given the central bank's statements, lowering of exchange rates appear to be one of the primary tools being utilized to combat deflation. In determining how the koruna will perform from here - an important question to be answered in this context is how well the Czech central bank will control inflation rates going forward. Economic growth forecasts for the Czech Republic appears to be positive, with average wages having risen more than expected in the last quarter of 2014 and growth reportedly having increased by 2% for 2014. Additionally, with rising oil prices, deflation may not be as great a concern going through to 2016 and further currency weakening will not be necessary.

In light of the above scenarios, a potentially valuable arbitrage opportunity may exist. While the more likely scenario is that the koruna will move with the Euro, there is the possibility of the koruna weakening while the euro gains strength. Should inflation rise significantly in Europe with increased economic growth but not in the Czech Republic - then the koruna would likely fall by a significant margin. In this context, a possible strategy is to take a long position on the euro and a short position on the koruna. While the more likely scenario is that the currencies would move together and this strategy would act as a hedge, a fall in the koruna would mean a profit on both sides of the trade.

In conclusion, I broadly expect the Czech Koruna to follow in lockstep with the Euro given increased growth forecasts. However, this is contingent on continued improvement in economic growth in the Czech Republic. Should growth weaken significantly compared to that of the Eurozone, then a long EUR - short CZK trade would likely be profitable.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.