Wednesday, December 8, 2010

Central Europe escapes contagion from the Irish crisis

It almost seemed that the financial crisis that hit the global economy in 2009 had dispersed for good, when a new problem, related to the highly vulnerable situation within  the Irish banking sector, emerged in the euro area. Thus the risk premiums on government bonds in the periphery of the eurozone have again hit highs, indicating that  the aversion to risk in Europe is on the rise.

Remarkably, Central European forex and bond markets have reacted to the Irish crisis very cautiously thus far. As a matter of fact, these markets are thus repeating their  reaction to a similar crisis this last spring, when Greece was the affected country and  when the initial reaction of Central European markets was also very moderate. Just like in April or May of this year, only Hungarian fixed income instruments, which have priced in obviously higher risk premiums (the yields of Hungarian bonds and CDS  have increased by approximately 50 basis  points since the beginning of October),  have reacted negatively to the problems of Ireland.

The moderate reaction by Central European markets to Ireland’s problems is fairly  logical. Just like in the case of Greece, there is no risk of direct contagion through financial or trade channels; however, this perception of the Irish crisis in Central Europe might only change if the increase in risk premiums at the periphery of the eurozone threatened the growth of the entire monetary union, or if a (controlled or uncontrolled) bankruptcy of some of the eurozone countries were imminent. Nevertheless, we do not find ourselves at such a stage at the moment, and  therefore we still  consider any major depreciation of Central European currencies or a major decline in  bond prices to be temporary rather than  long-term, and consequently we consider  this to be an attractive opportunity to take long positions in CZK, PLN and HUF, and in the government bonds of the relevant countries.

Czech Republic

The Czech koruna significantly underperformed the region last week. It came from a sideways mode at the beginning of the week to a defensive one. Interestingly this defensive mode was triggered by the rising hopes for Irish bailout,  which was rather applauded in the rest of the region. The weakness of the Czech currency was probably the effect of the lowest yields in the region that makes it attractive funding currency for regional carry trades, which is even more the case after recent dovish comments from CNB. Also the recent increase in EURIBOR could have boosted the attractiveness of the koruna as  regional funding currency.  From
the beginning of the month the Czech koruna, in contrast with the rest of the region, started to exhibit negative correlation to the S&P 500 index. That is not typical for emerging market currency and points to the possibility of carry trade emergence.  

Given the fact that week  ahead is, regarding domestic releases, not interesting, we expect the global sentiment to be  main driver on the Czech markets.  We are curious to see whether low yielding koruna is able to appreciate that.

Fixed income
The Czech bond market has been playing a catch up process with core bond markets as it had previously absented from the sell-off experienced in the first half of the November. As a result the Czech bond yield curve steepened in a bearish fashion and for example the 10Y bond yield jumped by more than 10 bps. Moreover, yields have continued to rise even at the beginning of this week, while the market shrugged off the positive comment from Finance Minister Kalousek, who indicated that the public budget gap for this year should be lower than the original target (5.1 % of GDP instead of 5.3% of GDP).

Full report:Central Europe escapes contagion from the Irish crisis 

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