Poland

The European economies are facing a major deflationary shock. We recommend that investors stay long a basket of Central European (CE3) domestic bonds. They should also upgrade CE3 bonds and stocks in their respective EM portfolios.

Domestic bond yields in the three major central European markets have recently inched up more than their German counterparts. This is despite economic growth staying quite weak in CE3. What should investors make of it (Chart 1)? Chart 1 CE3 Bond Yields Will Struggle To Fall As Core Inflation Stays Above Target CE3 Bond Yields Will Struggle To Fall As Core Inflation Stays Above Target Our take is that the CE3 yield differential over German bunds will widen in the coming months. That is due both to CE3 currency depreciations and diverging inflation outlooks. CE3 currencies are headed lower as growth in core Europe will continue to struggle.In addition, persistently high wage growth entails that core inflation in CE3 is unlikely to fall any further in the coming months, even if growth disappoints. The end of their disinflation cycle will prevent CE3 bond yields from declining considerably in the next six to nine months. Currencies And Bonds: The Drivers And Outlook CE3 currencies are heading lower vis-à-vis the greenback and the euro. That is because a crucial driver of these currencies—the growth outlook in core Europe—remains tepid (Chart 2). That is unlikely to change much going forward. Uncertainties surrounding Trump’s looming tariffs on Europe will continue to hurt business sentiments and growth in Europe. While the timing of tariffs is unknown, European capitals are preparing for executive actions shortly after Trump’s inauguration on January 20. A weak CE3 currency outlook is also negative for CE3 domestic bonds. Chart 3 shows that a depreciating currency usually coincides with a widening yield differential of CE3 domestic bonds over German Bunds.  Chart 2 Weak Growth In Core EuropeDrives CE3 Currencies Down Weak Growth In Core EuropeDrives CE3 Currencies Down That means CE3 bonds are set to underperform their German counterparts in common currency terms as both drivers of return (‘spreads’ and currency) will work against them. Apart from the currency impact, the CE3 inflation outlook is also bond-negative. Core inflation in the central European economies appears to have bottomed out for now.  Chart 3 CE3 Yield Differential With Bunds Usually Widen When CE3 Currencies Weaken CE3 Yield Differential With Bunds Usually Widen When CE3 Currencies Weaken The reason is persistently high wage growth – mostly due to severe labor shortages. The labor force participation rate is very high in these three countries, leaving little spare capacity in the labor force (Chart 4). Since such demographic challenges cannot be resolved anytime soon, wage growth rates will remain steep in the foreseeable future. Chart 5 shows that wage growth rates dictate CE3 core inflation. The latter, therefore, will likely hover above the central bank’s upper target bands in the foreseeable future. That, in turn, will put a floor under bond yields.  Chart 4 CE3 Labor Shortages Are A Structural Issue CE3 Labor Shortages Are A Structural Issue The bottom line is that CE3 domestic bond spreads versus German bunds will widen both due to CE3 currency weakness and cyclical inflation outlook. That calls for underweighting CE3 domestic bonds vis-à-vis bunds in fixed-income portfolios. CE3 bonds will also underperform their EM counterparts on a similar logic: the cyclical disinflation process is over in CE3 but not in most EM economies. As such, CE3 will likely witness relative bond yield widening vis-à-vis elsewhere in EM.  Chart 5 High Wage Growth Rates Will Keep Core Inflation Above Targets High Wage Growth Rates Will Keep Core Inflation Above Targets A Whiff Of Stagflation?Weak core European growth usually depresses central Europe's highly connected economies. Indeed, the persistent contraction in European manufacturing orders points toward muted CE3 growth ahead (Chart 6).  Chart 6 Weak Core European Growth Hurts CE3 Economies Too Weak Core European Growth Hurts CE3 Economies Too The latter’s domestic headwinds will accentuate that weakness. These headwinds will hurt the Czech and Hungarian economies much more than the Polish economy (details below). However, as mentioned, inflation will remain above the central bank targets everywhere. That suggests a stagflationary environment. Real policy rates in CE3 have not only turned positive, but they are also higher than pre-pandemic levels (Chart 7, top panel). The same can be said about real bond yields.  Chart 7 Monetary Conditions in CE3 Have Tightened Meaningfully Monetary Conditions in CE3 Have Tightened Meaningfully Real bank lending rates have also become restrictive, especially in Poland and Hungary (Chart 7, bottom panel). Put differently, monetary conditions have tightened meaningfully, which is growth-negative.The central banks of Poland and the Czech Republic recently revised down their growth projections for 2025, while revising up their inflation projections. The Polish and Hungarian central banks have also paused their easing cycles. The Czech National Bank lowered its base rate by 25 basis points earlier this month but acknowledged that inflation will remain above the target next year.All this indicates that policymakers are bracing for a stagflationary environment, in which growth remains low but inflation remains above the central bank’s targets.This also means further policy rate cuts will be difficult to come by. The upshot is that real borrowing costs will remain relatively high, further weighing on growth.Data indicates that domestic demand is already weak, particularly in the Czech Republic and Hungary. This can also be seen in retail sales volume levels – which have remained below their 2021-22 peak (Chart 8).  Chart 8 CE3 Retail Sales Volume Levels Are Still Below 2021-22 Peaks CE3 Retail Sales Volume Levels Are Still Below 2021-22 Peaks Fiscal policy has been a headwind, too, particularly in the Czech Republic and Hungary this year. Next year, however, the fiscal thrust will be only marginally negative, as per the IMF. To be sure, Poland is much less exposed to a struggling core Europe than the other two. The country is also set to receive a significant EUR 9.4 billion of EU grants and loans in the coming months (in addition to the EUR 6.3 billion they received in 2024 so far). This will help put a floor under its growth, as those funds will be deployed in various infrastructure projects. Overall, the Polish growth will fare relatively better than the other two. Polish core inflation will also likely perk up more than others. Czech inflation, on the other hand, will be the least pronounced. Geopolitical Risk Premium Spikes In Near TermThe Ukraine war escalated in a way that caught global investors’ attention on November 18 when US President Joe Biden gave Ukraine approval to use long-range missiles against Russia, including targets in the Russian heartland.Biden’s action stemmed from North Korea’s deployment of nearly 10,000 troops to fight Ukrainians near Kursk, Russia, where Ukraine invaded in August. The United Kingdom also gave approval for Ukraine to use long-range missiles. Ukraine promptly staged attacks against Russian supply lines using these missiles, triggering a harsh Russian reaction.Russia retaliated by firing a new hypersonic missile against Ukraine and revising its nuclear doctrine to lower the threshold for the use of nuclear weapons. Previously Russia only said it would use the bomb in the event of an existential threat to the state. Now Russia says it will consider an attack by a non-nuclear state (Ukraine) allied with a nuclear state (e.g. the US or UK) as a joint attack and potentially worthy of a nuclear retaliation. In particular, an extensive Ukrainian barrage of US-made missiles and drones targeting interior Russian cities could cross the new threshold.That is a convincing reason for Ukraine to limit the use of the missiles to targets close to its border, sporadically and only to hit military supply lines. Kiev does not have an interest in crossing Russia’s red lines and provoking a nuclear attack when it cannot be certain of the extent of that attack, the targeting, or that NATO would retaliate. Russia, for its part, would prefer not to use nuclear weapons because of the potential radioactive cloud close to home and the risk that NATO would retaliate by staging a conventional military strike against Russian forces operating in Ukraine. The Kremlin cannot be certain since the NATO states have a strong interest in preventing nuclear blackmail from becoming a new norm.Ultimately, Russia will use nukes if Ukraine goes too far – otherwise, it would not have staked its credibility on this new threat. Note that there is a high probability of near-term escalation of the war, including nuclear brinksmanship, even if the odds of a nuclear detonation remain in the low single digits.First, Ukraine’s fear of abandonment – and need to gain leverage ahead of any ceasefire talks – forces Kiev to escalate the war in the short run.Ukraine expects Trump and the Republicans to reduce military and financial aid since they were elected on the back of inflation and will seek to cut government spending. A loss of American support will signal to Europe that the war is effectively decided, as Ukraine will never join NATO.The Europeans want the war to end sooner rather than later because they fear the danger of a spillover into NATO territory as well as rising domestic political opposition. German and French leaders have already spoken to Vladimir Putin since Trump’s election, as they see the writing on the wall. Thus, Ukraine must take the initiative to prevent the West and Russia from foisting a ceasefire upon it, which is precisely what occurred in 2015 after Russia invaded Crimea.Second, the outgoing Biden administration views the incoming Trump administration as a threat to American democracy and a friend to Russian strategy. Trump wants to bring the war to a rapid ceasefire, but Russia would then succeed at establishing a sphere of influence and exposing a lack of resolve on the part of the Western democracies. Hence, Biden is attempting to speed up financial and military aid to Ukraine so that it can improve its war efforts, increase its leverage, and potentially create enough momentum to prevent Trump from utterly abandoning Ukraine or approving a lopsided ceasefire in Russia’s favor. Thus, the war is escalating as we go to press and will continue for at least the final two months of Biden’s “lame duck” presidency. After that, Trump’s inauguration on January 20 creates a clear diplomatic avenue for the reduction of tensions. Later, after Trump takes office, another risk will emerge for central Europe: the risk that Russia will stage a provocation against a NATO country to test whether Trump will “defend every inch” of the alliance’s territory, as Biden pledged to do. If Trump hesitates, Russia will undermine Eastern European trust in NATO, increasing the central European geopolitical risk premium. If not, Russia knows its limits for a while. Bottom Line: There is a major increase in Russia-NATO tensions around the endgame in Ukraine, which should inject a risk premium into Polish, Hungarian, and Czech currency and assets at least for the next few months around the US power transition and possibly for a while longer. Investment ConclusionsCurrency: The Polish zloty has been the strongest of the three currencies over the past year as the markets celebrated Poland’s political return to the European manifold after the elections late last year. Now that event has been largely priced in, and the geopolitical risk is rising again. Investors should expect a relapse in Poland’s currency and share prices. A weak core European growth outlook means all CE3 currencies have a further downside compared to the greenback. Currency investors should stick with our recommendation of shorting an equal-weighted basket of CE3 currencies versus the greenback (Chart 2, above).Fixed Income: Considering the inflation outlook and currency prospects, we recommend that EM domestic bond portfolios downgrade the Czech Republic from overweight to neutral and Poland and Hungary from neutral to underweight.Investors should also take the same stance relative to German bunds: neutral the Czech Republic and underweight the other two (Chart 9).Notably, on October 21, 2024, we closed our long position in Czech domestic bonds. For USD-based investors, this recommendation has returned a 12.7% gain since its inception on December 08, 2022.We also booked profits on our trade “Pay Polish 2-year swap rates / Receive Czech 2-year swap rates,” which yielded 120 bps gains since its initiation on November 22, 2023. Equity: Given the weak growth outlook, the CE3 stock prospects remain lackluster. Tight monetary stances in all three countries and a negative fiscal thrust in the Czech Republic and Hungary will add to their headwinds. EM equity portfolios should downgrade both Polish and Czech stocks from overweight and neutral, respectively, to underweight. Hungary should also remain underweight (Chart 10).  Chart 9 Downgrade CE3 Domestic Bonds Relative To Their EM And German Counterparts Downgrade CE3 Domestic Bonds Relative To Their EM And German Counterparts Chart 10 Weak Core European Outlook Will Weigh On CE3 Stock Performance Weak Core European Outlook Will Weigh On CE3 Stock Performance The rise in geopolitical risk in the region will likely exacerbate pressures on CE3 assets in the short term.Rajeeb PramanikSenior EM Strategistrajeeb.pramanik@bcaresearch.comMatt Gertken Chief Geopolitical Strategist mattg@bcaresearch.comFollow me onLinkedIn & X 

The disinflation process is over in Poland and Hungary. Only the Czech Republic will see its core inflation meet its central bank target this year. The reason is much tighter labor market dynamics in the first two. Investors should continue to short a basket of CE3 currencies vis-à-vis the US dollar.

Poland’s inflation will stay elevated. And yet, its return to the European mainstream has improved its financial market outlook. Accordingly, we are recommending new trades on Polish equity, fixed income, and currency.

Real wages are set to rise in CE3 economies with implications for their asset markets and currencies. Of the three, Polish assets and the zloty are the most vulnerable.

The growth and inflation profiles of the three central European countries are set to diverge. The outlook for Polish and Hungarian Bonds are not attractive anymore. Book profits on them. Instead, initiate a new trade: pay Polish / receive Czech 10-year swap rates.

Executive Summary Poland: Wages Are Surging Poland: Wages Are Surging Poland: Wages Are Surging Hungary is exhibiting classic signs of an overheating economy –as rising inflation coincides with very strong domestic demand. Yet, authorities are still pursuing very stimulative monetary and fiscal policies. The upcoming appointments of new Czech National Bank (CNB) governor Aleš Michl and three new monetary policy board members entails a dovish shift in monetary policy. Core inflation in Poland will continue to rise due to the unfolding wage-price spiral. The reluctance of policymakers to tighten monetary and fiscal policies substantially in such an environment heralds a weaker currency and higher local bond yields. Continue to underweight Central European equities and local currency bonds relative to their respective EM benchmark. Underweight Central European local currency bonds within European core bond portfolio. Recommendation INITIATION DATE RETURN Receive Czech And Pay Polish 10-Years Swap Rates 2022-03-08 100 BPS Long CZK/Short HUF 2021-06-03 12.4% Short PLN/Long USD 2022-03-02 3.1% Bottom Line: The Hungarian and Polish economies are overheating, yet their monetary and fiscal policies remain accommodative. This is negative for their currencies and local bonds. Even though the incoming leadership of the Czech central bank will cultivate a more dovish stance than the current leadership, Czech macro policies are less stimulative than those in Hungary and Poland. By extension, the Czech currency and local bonds will outperform their Hungarian and Polish counterparts.   Hungary: Classic Overheating Chart 1Hungary Is Overheating Hungary Is Overheating Hungary Is Overheating The Hungarian economy is exhibiting signs of classic overheating as rising inflation coincides with very strong domestic demand (Chart 1). Yet, authorities are not tightening monetary and fiscal policies meaningfully. The central bank is well behind the inflation curve. Accordingly, the currency will continue to depreciate and local bond yields will rise. The only way to reverse these dynamics is for authorities to tighten monetary or fiscal policies dramatically, which will likely cause a recession. Looking forward, authorities will continue to pursue their pro-growth agenda despite the unfolding wage-price spiral. Inflation is broad-based and will accelerate further. High inflation is not limited to goods. Core, trimmed-mean and service inflation are also very high, in some cases in double digits (Chart 2). Chart 2Hungary: Inflation Is Broad-Based Hungary: Inflation Is Broad-Based Hungary: Inflation Is Broad-Based Chart 3Hungary: Wage Growth Is In Double Digits Hungary: Wage Growth Is In Double Digits Hungary: Wage Growth Is In Double Digits Hungary’s labor market is tight, and wages are surging (Chart 3). Notably, wage growth is in double digits and is well above core inflation. Wage growth will remain robust as the government is set to boost public wages and the private sector is struggling to fill vacant positions. Employment is at an all-time high, and the number of unemployed people is approaching pre-pandemic lows (Chart 4). Strong employment and solid real wage growth will support consumer spending for now.   Despite a major slowdown in the euro area, Hungarian exports will suffer less than those of other EU members. Almost 50% of Hungary’s manufacturing output comes from automotive, food and beverages, as well as industrial electrical equipment sectors. Demand for these sectors remains robust despite a potential drop in demand for consumer goods in the EU.   Despite the central bank raising rates by a cumulative 530 bps since June 2021, real policy rates and real commercial bank lending rates (deflated by core CPI) are at all-time lows, and money and private credit are booming (Chart 5). In brief, the central bank remains behind the inflation curve. The National Bank of Hungary (NBH) has also been the most aggressive central bank in the region in monetization of public debt and corporate debt. There is little evidence to suggest that it is planning to tighten liquidity as a means of reining in inflation. Chart 4Hungary: Labor Market Is Currently Very Tight Hungary: Labor Market Is Currently Very Tight Hungary: Labor Market Is Currently Very Tight Chart 5Hungary: Money And Credit Are Booming Hungary: Money And Credit Are Booming Hungary: Money And Credit Are Booming Chart 6Hungary: Twin Deficit Hungary: Twin Deficit Hungary: Twin Deficit Fiscal policy will remain loose and unorthodox measures will likely persist. Government primary spending has reached 46% of GDP and is unlikely to retrench much. In particular, in response to the EU’s recent €7.2 billion (4.6% of GDP) cut in funding to Hungary, prime minister Orbán has announced spending cuts and tax hikes to prop up government revenues (Chart 6, top panel). The government has imposed “windfall” taxes1 on some firms or industries where profits are excessive from the government’s perspective. The majority of spending cuts (€3 billion or 2% of GDP) will be in public investments. Meanwhile, authorities continue subsidizing household utility bills and raising public wages and pensions. This will keep consumption strong.   A very wide current account and trade deficits are also signs that the economy is overheating (Chart 6, bottom panel). Bottom Line: Super-loose monetary and fiscal policies amid an overheating economy warrant further currency depreciation and higher bond yields.  The Czech Republic: A Policy Shift Coming The recent appointments of Czech National Bank (CNB) governor Aleš Michl and three new monetary policy board members entails a dovish shift in monetary policy. Notably, Aleš Michl, a current board member of the monetary policy committee, has been a strong opponent of the CNB’s hawkish stance alongside current board member Oldřich Dědek. Both men have been the only two of the seven-member  committee to vote against rate hikes in the past eight meetings. In addition, President Zeman recently appointed three new members to the monetary policy committee to replace hawkish members that have reached the end of their terms. These new appointments are likely to be aligned with the forthcoming CNB governor’s dovish approach to monetary policy. Chart 7Czech Output Gap And Core Inflation Czech Output Gap And Core Inflation Czech Output Gap And Core Inflation Altogether, these appointments will result in a major shift in the CNB’s monetary policy board, whereby at least four out of the seven board members will likely vote against further rate hikes after July. Therefore, the CNB policy will undergo a dovish pivot. This will occur at a time when genuine inflation is still high and inflationary pressures are intense: The very large positive output gap heralds persistent inflationary pressures (Chart 7, top panel). Indeed, core and trimmed-mean CPIs are surging, which suggest that inflation is broad-based (Chart 7, bottom panel). Job vacancies exceeding the number of unemployed people entails a very tight labor market (Chart 8). The upshot is rising wages (Chart 9).   Domestic consumption remains robust due to considerable household income gains. Chart 8The Czech Republic: Labor Shortages Are Pervasive The Czech Republic: Labor Shortages Are Pervasive The Czech Republic: Labor Shortages Are Pervasive Chart 9Wage Growth Is Lower In Czech Than In Hungary And Poland Wage Growth Is Lower In Czech Than In Hungary And Poland Wage Growth Is Lower In Czech Than In Hungary And Poland Chart 10Fiscal Policy Is Tightening More In Czech Than In Hungary And Poland Fiscal Policy Is Tightening More In Czech Than In Hungary And Poland Fiscal Policy Is Tightening More In Czech Than In Hungary And Poland On the one hand, a dovish monetary policy shift is negative for the Czech koruna. On the other hand, the country’s fiscal thrust will still be negative this and next year (Chart 10). This is in contrast to Hungary and Poland. Besides, the central bank considers a weak currency to be a risk to its “fulfilment of price stability” and regards the “easing of the monetary conditions” as “inappropriate”. Last month, the CNB board convened in an emergency meeting to announce the selling of foreign exchange reserves to stem volatility in the currency. The Czech Republic has a lot of foreign exchange reserves that could be utilized to stem any large moves in the koruna. Even newly appointed governor Aleš Michl considers a strong koruna to be an important part of his mandate. His recent comments to local media suggest that the CNBs’ intention is to defend the currency against any medium to long-term weakness: “I want a strong koruna based on long-term cash flows to the country and investor interest in the Czechia. The koruna has not strengthened in trend since 2008. Everyone is only evaluating short-term fluctuations, but they do not perceive this significant change. The koruna will only be strong if we have long-term balanced public finances.” Overall, the selling of foreign exchange reserves to defend the currency will tighten monetary conditions and prevent short-term interest rates from falling. Whenever a central bank sells foreign currency, it is forced to purchase local currency which lowers commercial banks’ excess reserves at the central bank. The latter could reduce money origination by commercial banks. While long-term bond yields could rise as the central bank falls behind the inflation curve, the currency will likely be range bound versus the euro for some time. Bottom Line: Even though the central bank is shifting into a dovish mode, it will maintain the policy of a strong currency. Plus, the fiscal policy will be tightening, which is not the case in Hungary and Poland. We reiterate our long CZK / short HUF trade. Poland: Misguided Macro Policy Chart 11Poland: Wages Are Surging Poland: Wages Are Surging Poland: Wages Are Surging Inflation in Poland will continue to rise due to the unfolding wage-price spiral (Chart 11). Besides, the central bank is still behind the inflation curve, and fiscal policy has not tightened substantially. The reluctance of policymakers to tighten monetary and fiscal policies amid the wage-price spiral warrants a weaker currency. Also, a top in domestic bond yields might not be imminent. A buying opportunity in Polish local currency bonds will emerge only when authorities take measures to bring down inflation and when geopolitical tensions between Russia and the west abide. The central bank and government continue to blame inflation on the war in Ukraine, i.e., on supply-side factors rather than excessive domestic demand. Chart 12Poland: Consumer Spending Has Overshot Poland: Consumer Spending Has Overshot Poland: Consumer Spending Has Overshot Contrary to policymaker rhetoric, Poland is experiencing an inflationary boom, whereby rising inflation is not only the result of supply-side bottlenecks but is also due to excessive demand. Chart 12 illustrates that retail sales have overshot above a reasonable uptrend trajectory. Critically, the labor market is very tight. As a result, wage growth is skyrocketing both in nominal and real terms. With productivity growth well below wage growth, unit labor costs are accelerating. This will squeeze company profit margins and lead these to hike selling prices to protect profit margins. With such robust income growth, consumers might accept higher prices and the wage-price spiral will likely be sustained. Meantime, fiscal policy will remain accommodative at least throughout early 2023, until the scheduled parliamentary elections take place. The government has provided subsidies on energy and has cut the VAT rate. These programs effectively amount to stimulus for households. Chart 13Poland: Interest Rates Are Very Low/Negative Poland: Interest Rates Are Very Low/Negative Poland: Interest Rates Are Very Low/Negative In addition, the central bank will not likely hike rates aggressively. Recent comments by central bank governor Adam Glapinski appear to suggest that the National Bank of Poland (NBP) is likely to pause or slow its rate hikes. Even though the central bank has hiked its policy rate by 590 bps in the past 12 months, real policy and prime lending and mortgage rates as well as government bond yields remain very negative (Chart 13). This signifies that the monetary tightening has been insufficient. Lastly, in the current geopolitical climate, Poland is the most vulnerable among Central European nations to any escalation between Russia and the west. This is due to its extensive border with Ukraine, and due to it being the transit route for arms into Ukraine from the west. Poland has adopted a hard stance on Russia. This makes Poland an easy target for Russian rhetoric. While chances of direct conflict are slim, any further escalation by Russia will make Polish financial markets vulnerable to selloff. Bottom Line: For now, investors should continue to underweight Polish domestic bonds within both EM local currency bonds and core European bond portfolios. Also, we continue to recommend shorting PLN versus the USD. Investment Recommendations The Hungarian and Polish economies are overheating, and their monetary and fiscal policies remain accommodative. This is negative for their currencies and local bonds. Even though the incoming leadership of the Czech central bank will be more dovish than the current leadership, Czech macro policies are less stimulative than those in Hungary and Poland. Hence, the inflation outlook is more benign for the Czech economy than it is in Hungary and Poland. By extension, the Czech currency and local bonds will outperform their Hungarian and Polish counterparts. Chart 14Our Trade: Long CZK / Short HUF Our Trade: Long CZK / Short HUF Our Trade: Long CZK / Short HUF In light of this, we recommend the following to investors: Underweight Central European local currency bonds within European core bond portfolio. Keep the long CZK / short HUF trade (Chart 14); Hold onto the short PLN / long USD trade. Maintain the relative rates trade of receiving Czech and paying Polish ten-year rates. This spread has widened by 100 bps since our recommendation on March 8, 2022. Maintain underweight in local bonds and equities for Central Europe relative to their respective EM benchmarks.   Andrija Vesic Associate Editor andrijav@bcaresearch.com   Footnotes 1     A windfall tax is extra tax on profits of a particular company or industry that is deemed to have earned excessive profits.