Despite the CNB hiking rates twice over the summer, the koruna remains rather weak while core inflation is accelerating on the back of rising wages. The CNB’s forecasts assume one more hike in the third quarter, and the market has already priced it in. We expected a hawkish outcome from the latest CNB meeting that would see the koruna strengthen. However, although the bank’s short-term outlook did prove hawkish, the FX market has not reacted. We change our CNB call in accordance with the market view of September hike. We still expect another hike in November.
The CNB’s August forecasts assume two hikes in the third quarter and one more in the final quarter of the year. Compared to our outlook, the CNB projection had expected higher inflation and a weaker koruna. July’s inflation reading proved us right, with inflation decelerating from 2.6% to 2.3%. The slump was mainly due to a drop in food prices, while core inflation accelerated. The CNB has signalled that it will not react to volatility in food prices and that it considers the strength of the core reading to be the key driver of its decisions. We see the trajectory of inflation as supporting a hawkish view.
EUR/CZK is a second factor supporting the CNB hawks. Despite the bank’s relatively bullish forecast for this year, the FX rate has not moved notably. It is still being driven more by the risk-off mood affecting all EM currencies than by widening interest rate differentials. Thus, the koruna is not helping tighten overall monetary conditions, implying that more tightening will have to be done through interest rate increases.
Besides FX, the bank board is very concerned with the labour market. Wage growth does not seem to be easing, propelled by excess demand for labour. Moreover, the government has agreed to raise the salaries of public servants by 8% on average starting next year.
Given strong core inflation, a weak koruna and the prospect of sound wage growth, we change our CNB call and add a September hike to our outlook. We still believe that there will be one more hike in November and three hikes in next year. The repo rate should thus reach 2.5%, which is very close to its neutral rate.
Analogously, we update our call on the IRS and CZGB yield curves. The IRS curve continues to flatten, with the 2y10y spread recently at 25bp. We expect additional CNB rate hikes to accelerate the rise of the short end, with the 2Y IRS set to reach 2.25% by the end of the year and grow further to 2.75% over the course of 2019. This should result in further curve flattening, and we expect the 2y10y spread to reduce to zero in the second half of next year. Slightly stronger inflation and record-high issuance suggest that CZGB yields will follow the upward trend despite likely good demand, with the yield on the 10y CZGB reaching 2.4% by the end of the year and later increasing to 2.7%.