The koruna will determine whether CNB rates will go below zero

In reaction to Thursday’s contemplation by Tomáš Holub from the Czech National Bank in the Hospodářské noviny daily over the possibilities of cutting rates below zero, the yields of Czech government bonds with shorter maturities fell into clearly negative territory. Thus investors have to pay for being allowed to lend their money to the Czech government. At the moment it is just a few basis points but it is probably appropriate to ask how far this situation (which is certainly convenient for the Czech Ministry of Finance) can go.

We should look for the answer to this question on the forex market, i.e., in the exchange rate of the koruna. If pressure on the Czech currency to appreciate persists, and if the CNB has to intervene and is compelled to buy even larger foreign currency volumes to add them to its forex reserves, this will boost the natural pressure on short-term interest rates to fall. If the CNB subsequently considers a possible increase in its forex reserves to be highly inconvenient, the central bank will have to resort to introducing negative interest rates in some way unless it wants to unleash the exchange rate (and let the koruna strengthen). Everything is legislatively complicated, as the CNB should not actually be allowed to charge negative interest rates – yet Thursday’s interview indicates that the CNB already knows how to circumvent even this. And how far should Czech interest rates possibly go? To alleviate pressure on the koruna at least slightly, the CNB should cut the Czech rates at which commercial banks deposit their money with the central bank to at least the level of the ECB deposit rate, i.e., -0.20%. It would probably be enough to cut the Czech rates to a few points below this rate. The Czech Republic is unlikely to need to drive its rates to the Swiss-Nordic extreme. Official rates in Switzerland and Denmark stand at -0.75%, Sweden’s repo rate stands at -0.35% and its deposit rate even at -1.1%!

Naturally, there is no guarantee that negative official interest rates will really be put in place in the Czech Republic. As described above, everything depends on the koruna and the growth of forex reserves, i.e., whether there will be any objections to a possible increase in forex reserves. Thus it is partly a self-fulfilling scenario, where the market speculations alone on this happening may actually trigger such a scenario. And predicting whether or not events like this will happen in the end is hard, indeed. No matter if this or that scenario happens, short-term koruna interest rates will be really very low for some time.