Political crisis in Italy slams the Euro, hits ten month low

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29 May 2018

thomasdodds

The last few days were a throwback to the kind of political crises that used to hammer European assets regularly a few years back.

I
talian President, Mattarella, refused to appoint the populist coalition candidate for finance minister on the basis that doing so would risk a ‘back door’ exit from the Euro, without a democratic mandate to do so. Both populist parties, Five Star Movement and the League, had campaigned on the basis of continued membership in the common currency.

Prior to the weekend’s events, the previous week saw the dollar rally pause, as US rates dropped sharply in the aftermath of the publication of dovish Fed meeting minutes. The Monday holiday in both London and New York means that the overall impact of the Italian crisis in worldwide risk assets is not yet clear.

This week, markets attention will be focused on both sides of the Atlantic. In Europe, headline risk from Italian and Spanish politics will once again be key to Euro trading. In the US, a slew of first tier economic data will be released, particularly consumer inflation data and the key May payrolls report out on Friday.

Major currencies in detail

GBP

Disappointing inflation data and the sense of lack of progress in Brexit negotiations took a toll on the Pound. The Italian news also pressured the Cable downward, without doing much to push Sterling up against the Euro. With only the PMI indices of business activity on tap this week, we expect trading in Sterling to react mostly to news elsewhere, particularly the deluge of economic data out of the US and the headlines from the Italian crisis.

EUR

Further weakness in European PMI indices of business activity was overshadowed by political news. In addition to the institutional crisis brewing in Italy, Spain’s prime minister Rajoy, faces a no confidence motion, the outcome of which is, as of now, impossible to predict.

The blowout in short-term Government bond spreads in Italy, brought this key stress indicator to its highest level, in five years, in a single week of trading. While an establishment figure was given a mandate to form a government, it will not have enough parliamentary support and fresh elections seem likely. We think that there is no appetite in Italy for an exit from the Euro, and this means that either the populists renounce explicitly any steps in that direction or they will suffer electorally. For now, however, uncertainty reigns and the common currency is having a rough time of it.

USD

The minutes from the last Federal Reserve meeting published last week were more dovish than the market expected, with suggestions that Fed officials were quite happy to allow a temporary overshoot in headline inflation, and that there is no sense of urgency in terms of accelerating the timetable for hikes. This set the tone for a rally in Treasuries, which picked up steam on political news out of the Eurozone, bringing the key 10-year yield back below the psychological threshold of 3%. This stopped the rally of the dollar against most major non-European currencies. The latter continued to underperform as the situation in Italy deteriorated over the weekend.

All eyes are on the key data on consumer inflation (Thursday) and the monthly payrolls report (Friday).