## Sunday, May 21, 2017

### EURCZK: the distortions of the market may fade away now

About two weeks ago, my broker (similarly to at least some others) increased the margin requirements for CZK-based pairs by a factor of 20 – the justifiable reasons seem non-existent to me. (Update: They warned by a factor up to 20 to make the clients close the position, but then they increased it 5-fold "only", still too high for me.) It was the 4th annoying shocking change of the rules (and the most far-reaching one) so I decided that it was no longer usable and closed my position – and extracted all the money – with a nontrivial but modest 50% return on the money I reserved for that account. The plan was at least 300% – and even by this point, I could have easily achieved 200% if I were a little bit less cowardly.

I am not rich but I am more impartial now which is a more precious value. ;-)

You may still make big profits if your broker is more well-behaved. This is the chart of EURCZK since Fall 2004. Click to magnify the graph. You see that at the end of 2004, one euro was some 31 crowns (CZK). It was strengthening by some 4% i.e. one crown per year and reached the low of 23 crowns per euro in mid 2008. The Lehman Brothers-like events weakened the crown almost up to 29 in 2009. CZK strengthened back towards 24 or so by 2011 and was expected to return to the 4% strengthening per year.

But in late 2013, when CZK was already unnaturally weak at 25.5 per euro, the inflation was near zero and officially because of the deflation fears (which I find largely irrational), the Czech National Bank switched to the side "majority of the board supports the interventions". Big currencies' banks have to buy bonds and do other quantitative easing exercises – a smaller nation like Czechia may simply weaken its currency to achieve a similar positive pressure on inflation. By printing CZK (about 1/6 of the crowns are actually printed physically, I recently learned, finally), they weakened CZK from 25.5 to 27, the new floor. Due to the risk that they're obsessed with it, the market actually decided that the fair rate was 27.5 where it was throughout 2014. But since some point in 2015, people were regaining common sense and they knew that these policies had to end. The crown returned very close to the strict floor, around 27 per euro, and it was sitting there throughout second half of 2015 and all of 2016.

The biggest excursion in 2016 from this rate 27.02 CZK per EUR occurred for 2 days after the Brexit referendum – the weakening went to 27.16, i.e. at most half a percent weakening. Fine. Inflation returned, was supported by higher food and fuel prices, accelerating economy, and EET the Big Brother cash registers. In early 2017, it became clear that the removal of the cap was just a matter of months.

If you look at the recent two months, different events are highlighted:

You see that EURCZK was sitting at the cap plateau 27.02 in March (the buy/sell prices were typically 27.01 and 27.03, so the spread is 2 hellers per euro), oscillated to 27.06 on March 17th, and according to the graph, even to 27.15 on March 30th. Actually the intraday high was around 27.25, almost one-percent weakening. That was caused by the disappointment of those who expected – without too many reasons – the cap to be lifted already on March 30th, one day before the official pledge (the rate was guaranteed above 27 up to the end of March 2017 – most people agree that this prolongation from the previous commitment, end of 2016, was a mistake). Everyone whose stoploss level was between 27 and 27.25 got burned.

The exit actually took place on April 6th, another Thursday. The crown oscillated a little bit afterwards – but never weakened past 27.11 after the exit – and it went to 26.6 in three hours, less than 2% strengthening during the afternoon. The motion was clear but modest and relaxed relatively to the experience with the Swiss franc - much like the Prague International Airport feels relaxed and rural relatively to the largest Western European airports. However, that was the strongest point for some time and during the following month, CZK even visited the region around 27.02-27.05 twice, on two Thursdays. It has spent a lot of time near 26.95 and 26.8 and other places.

Since the beginning of May, it finally looks like a strengthening trend. CZK has seen new record annual strengths, perhaps 26.38, and is currently sitting around 26.48, after the Wednesday impeachment weakening to 26.7 or so.

Czechia has the 18th largest absolute Forex reserves in the world and it's said that a half of this, some EUR 60 billion, corresponds to the crowns held by the speculators. You may see the graph to assure yourself that most of those bought the crowns in the recent year or so, especially the two months before the exit, at a rate that is very close to the plauteau level of 27.02.

They bought it because they "know" that the fair rate is substantially stronger for CZK, perhaps near 24-26 per euro. In spite of that, these people allowed the crown to sit near 26.9 and similarly ludicrously near-27 levels without interventions simply because these crowns were leaking and the speculators were satisfied with a very modest profit. The crown should strengthen 10% or so, they know, but if it strengthens just 0.5%, you may make the same profit if you have had bought a 20 times greater amount of CZK at 27.02.

To make a model of the market, you must appreciate that there are different kinds or strategies of the speculators:
1. There are the long-term, and I believe generally large and institutional, speculators who see the crown's getting some sustainable values at which the trade surpluses are near zero, perhaps 22-26 per euro. Those are generally expected to buy the crowns whenever the crown is weaker than 26 per euro. But they're not in a hurry – they still want to buy them as close to 27 as possible.
2. Speculators who may be aware of these future predictions but whose psychology is still attached to the past, to how they bought the crowns. They bought it at 27.02 so this gives them a "benchmark" helping them to decide whether they should buy or sell the crown. So they're not willing to sell the CZK when it's weaker than 27.05 – that was indeed the upper bound – but they're rather willing to sell CZK at 26.9 etc. because it still means a positive profit.
3. Regular traders who buy the dips and sell the upticks and try to make profit out of some mostly short-term oscillations, paying no attention to the long-term trends and predictions.
4. Regular momentum traders who may decide that there's already a trend that will continue, probably a strengthening one for CZK, and that's why they will buy CZK.
Now, the people in the group "2" are the reason why CZK was able to sit in the 26.9-like territory (away from any agreed fair price) for a month or so. But the people with this background, thinking, and strategy are gradually selling their CZK so their ability to sell extra CZK is going down. I think that the amount of money held by the people who are "almost unambiguously" in the group "2" must already be very low at this point, perhaps smaller than one billion euros worth of long crown positions.

It was the group "2" that could have made the crown "hugely weaken" (perhaps to 30 per euro, which the national bank could still tolerate for some time) because they may have needed to close the position but wouldn't find counter-parties. I have always been convinced that this wouldn't happen and I was right. The speculators are not complete idiots, they know the tale about the investment tourist (who ends up buying when things are expensive and selling when they're cheap) and most of them know that if things turn sour and CZK is worth 27.05 per Euro, they just wait. Indeed, that's what happened. Closing your long CZK positions at these points would be a textbook mistake and almost no one did it.

So the groups "1", "3", and "4" are increasingly deciding about the rate. For weeks, there have been many traders who are actually short CZK. It's been a relatively balanced market. These people who short CZK may hit stoploss levels which may accelerate the strengthening of CZK. The long-term trend seems obviously bullish for CZK (bearish for EURCZK) but most traders probably don't give a damn about such trends. And the EURCZK sentiment at a website actually says 100% bullish right now!

I find it unavoidable that the crown will be stronger than 26 per euro or so in one year, and maybe much stronger, while the probability that it will be weaker than 27 again seems negligible. The unemployment in Czechia is the lowest one in the EU. The crown is clearly underpriced according to lots of criteria, trade surpluses, shortage of employers, the ratio of PPP and nominal GDP which is a stunning 1.8, and the inflation in Czechia is generally faster than that in the Eurozone, having been – and expected to stay – at or above 2% for months and in the following months.

To protect CZK from the 3% upper bound of the "inflation tolerance band", the Czech National Bank is expected to raise the interest rates for the first time before the ECB does so. Right now, ČNB itself expects to raise the rates in the 3rd quarter of 2017 (July, August, September). Some traders "read in between lines" that ČNB could hike the rates in Q2, too. It may be earlier or later. It will generally be earlier if the CZK fails to substantially strengthen. It will be later if CZK will strengthen more than ČNB expects.

The result basically means that ČNB will change or not change the interest rates so that it will support some expected strengthening, anyway. If the crown fails to strengthen sufficiently without the help of a hike, ČNB will apply a hike, and that will attract new people to buy CZK. On the other hand, the probability of weakening back above 27 – or at least back above 27.1 – seems tiny now. It's a relatively safe bet.

You should use dips to buy CZK now. And because the swap points are almost zero – and may make a profit once ČNB increases the interest rates – it shouldn't be a problem for you to hold the CZK long position for an extended period of time. You actually could be holding CZK for years and CZK could strengthen by those 4% per year – or 200% if you enjoy some 50-to-1 leverage (and if your broker isn't making these things impossible by annoyingly playing with the margins, like mine did).

The reserves of the Czech National Bank, some 136 billion dollars right now, are huge relatively to almost all comparable countries (or according to the reserves per capita or even per GDP) but they're still 5 times smaller than the Swiss ones. So despite the differences in how the cap exit was communicated and other things, it's obvious that the long-term character of the Czech currency is bound to be analogous to the Swiss franc. There are just lots of them, traders bought them (CHF and CZK) because they thought it was a good investment at some point, the market became relatively liquid – but dominated by foreign owners – and CZK is therefore a minor but not negligible "reserve currency" (at least for big banks).

The only thing that the market needs to train itself to the notion that CZK may and should be held for longer periods of time is to wait. ;-) Time (as a gadget that flies) increases the time (the quantity) automatically. ;-) So whether you knew or respected the currency and the surrounding nation or not, CZK is automatically turning into an important enough international currency whose value seems rather stable and where you can park your money. The Bitcoin is famous and its owners are happy that they doubled their wealth in a year or so. But it's still true that the speculators hold about 3 times greater amount of wealth in CZK than they do in the Bitcoin. CZK is expected to strengthen much less quickly than the Bitcoin but it also seems to have much better reasons to be sure that it won't weaken much.

If you have a Forex account, I recommend you to gradually increase your long CZK position. You may want to buy it when it's weaker at least by 0.5% than the average of recent 2 days – this happens sufficiently frequently – and your stoploss should better tolerate a 2% weakening from every point – and weakening to 27.15 minus [the time since April 6th, 2017 in years]. With some of these reasonable insurances, the strengthening CZK may bring you profits for a year or years.

It may be that the Czech National Bank will intervene again and protect CZK to remain weaker than 25.5. But I think that this new level isn't at or above 26.00. And after some time, it may turn out to be obvious that stronger crowns than 25.5 must be allowed to prevent too high an inflation rate.

American traders may think about the USDCZK pair, currently at 23.63. It was at 26 in early 2017, 42 sometime in 2000, and 14.5 in mid 2008. Especially if you bet on EUR strengthening relatively to USD, it may be a good idea for you to short USDCZK instead which is expected to behave as a "somewhat amplified" (reverse) EURUSD.