With the end of the year rapidly approaching, traders and investors are busy squaring positions and taking profits in the lead up to the holidays. One of the most notably impacts has been the sustained downward pressure on the US dollar after the currency proved amongst the best performers of 2015, with the dollar index up 8.00% year-to-date. However, in the uncertainty leading up to the FOMC decision next week, the remains softer versus peers despite the potential for the unveiling of a new rate hike cycle. However, by comparison, Europe looks no closer to exiting crisis-driven policies and seems intent on keeping policy accommodative over the medium-term. The Czech Republic in particular has been mirroring the slowdown in Europe, marked by weak inflation and record low interest rates. With a major policy divergence approaching, USDCZK losses might present an exceptional opportunity to gain greater exposure to dollar upside in 2016.

The Fundamental Perspective

Akin to its neighbors in the Euro Area, the Czech Republic currently boasts ultra-low interest rates at 0.05% where they have sat since 2012 and are expected to remain for the foreseeable future according to the latest estimates. These measures have largely proved positive for the economy which has experienced substantially faster growth than neighboring countries with the third quarter GDP expansion printing at 0.50% after recording blistering 2.50% growth in the first quarter. On an annualized basis, the pace of GDP gains is estimated to be 4.50%, outstripping the entire G7 and many emerging markets as the country has largely managed to insulate itself from the problems facing other advanced economies. With unemployment on the mend, falling to multi-year lows of 5.90%, down from 7.70% at the beginning of the year. However, the concerning development has been disinflation and the potential invasion of deflation.

Unlike larger advanced economies, the Czech Republic has far more limited tools when it comes to fighting deflation and moving monetary policy towards more unconventional directions. At present, annualized consumer price inflation sits on the cusp of deflation, currently printing at 0.10% with the latest monthly figures slipping firmly into negative territory, recording a contraction of -0.40%. While forecasts show the measure improving in the second half of 2016, for the meantime it will prevent any monetary adjustments as policymakers work to prevent deflation. By comparison, US inflation is not substantially higher, however, in order for the Federal Reserve to maintain credibility, a rate hike looks imminent save any dramatic underperformance of economic fundamentals.

Even though the US economy is not growing as fast the Czech Republic, interest rates are expected to rise as high as 0.75-1.00% by the end of 2016 compared to 0.05% for the Czech economy. This will be one of the main catalysts for the continued ascendance of the US dollar over the coming year as efforts to tighten policy add to upward momentum. Without a rebound in inflation, Czech policymakers are unlikely to take any hawkish actions including a rate hike unless inflation conditions necessitate such a shift. While conditions remain accommodative, it should help employment continue to improve while buoying GDP growth and benefit weak inflation. However, should all these gains be felt, rates are unlikely to rise until after 2016 in a growing sign that the country will have to stick with crisis-driven policies for the foreseeable future.

The Technical Perspective

The Czech Koruna hit multi-year lows last seen in 2004 versus the US dollar back in March. Since peaking, the USDCZK pair has pulled back nearly 12% before finding substantial support on the downside. Based on the current price action and a combination of technical factors, the pair looks poised for a substantial run higher on this sustained pullback in prices. Even though the USDCZK is currently trending below both the 50-day and 200-day moving averages which will act as resistance in the near-term, the fact that that the moving averages recently saw the 50-day cross the 200-day to the upside is indicative of a strongly bullish bias.

Adding to the bullish conditions in the pair is the relative strength index which is approaching the 30 level that would indicate oversold territory for the currency pair and suggest Call positions to take advantage of the rebound. Adding to the potential for more upside is the emergence of a head and shoulders bullish pattern. Based on the neckline and forming right shoulder of the bullish pattern, ideal Call positions initiated at this level should target 25.680 on the upside and 26.070 as a secondary target. However, should the pair fall through the current trend-line serving as the neckline, it could be indicative of a deeper downward correction and potential reversal before making another run at recent multi-year highs.

Conclusion

With a nearing policy divergence likely to be the biggest driver of price momentum over the near-term, next week’s interest rate decision from the United States is likely to prove a pivotal moment for the USDCZK pair. Although the currency pair has experienced a substantial pullback recently on the back of dollar profit-taking, the long-term outlook for the pair remains upwards based on what is expected to be a bigger disparity between interest rates. Even though the Czech economy is humming along, the threat of deflation could force the Central Bank to accommodate policy further, negatively impacting CZK and boosting the pair even higher.

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