CEE FX: How vulnerable are regional currencies to fiscal risks? – BNY

October’s underperformance in Central and Eastern European (CEE) assets reflects market expectations that the region’s central banks cannot keep pace with the policy paths of the European Central Bank (ECB) and the Fed, according to BNY Mellon’s Geoff Yu. Carry returns on CE3 FX (Polish Zloty, Czech Koruna and Hungarian Forint) against EUR and USD have trailed cash returns. While CEE fixed income is stabilising, Yu cautions that France-related risk premia and Eurozone fiscal slippage could put pressure on CEE currencies against the Dollar, Swiss Franc and other safe havens.

Is policy divergence holding back CEE FX?

"We continue to expect CEE assets to perform strongly into year end, but October has been disappointing. FX weakness remains pronounced: An equally weighted carry basket of Central Europe 3 (CE3) currencies – CZK, HUF and PLN – against the EUR and USD is still running at just below a 1% year-to-date gain, close to 2.5pp below the cash equivalent. The EUR may have struggled over the past few weeks due to sovereign risk, while tightening financial conditions haven’t yet prompted the ECB to abandon its current policy trajectory."

"In the face of pressure from steepening yield curves, CEE central banks can hold the line on rates, leaving their respective currencies to bear the burden of adjustment. Real rates remain sufficient to anchor duration performance, and the issuance-weighted total return basket for CEE bonds continues to recover despite a more challenging environment for credit and emerging-market sovereigns with similar ratings profiles."

"Deficit risks are skewed to the upside in the near term if borrowing costs remain high and more energy support schemes are required this winter due to global supply challenges."

"Even without broad financial contagion, any associated risk premia imposed on Eurozone assets could be magnified for CEE economies, holding back performance against the USD, CHF and other perceived safe havens."

(This article was created with the help of an Artificial Intelligence tool and reviewed by an editor. Know more.)