EURUSD testing support

By David Morrison  |  02/10/2018 14:20

The euro has fallen sharply over the past week with a break below 1.1500 opening the possibility of further weakness

The EURUSD has fallen sharply over the past week. Ahead of the US Federal Reserve’s monetary policy meeting last Wednesday, the euro was trading above 1.1800 - its highest level since mid-June. But a 25-basis point rate hike from the Fed, a hawkish set of economic projections from the FOMC, allied with an upbeat press conference from Chairman Jerome Powell, helped to stem flows into the euro. Then the real damage was done in the following session after the new Italian coalition government delivered its budget proposal. While in line with manifesto commitments, the proposed budget blows a hole in the previous government’s promise (to the EU) to reduce and ultimately eliminate its budget deficit.

Italian yields soar

Italy’s two deputy prime ministers offered a budget with a deficit target of 2.4% of GDP for the next three years. But the European Commission (EC) has demanded that Italy progressively cut the fiscal gap to trim its debt. Italian equities and bonds have fallen sharply while the yields on government debt have soared. There was another slump first thing this morning after Claudio Borghi, the economic head of the ruling League party and head of lower house budget committee, said that most of Italy’s problems could be solved by having its own currency. This triggered a response from European Commission President Jean-Claude Juncker who said: "We have to do everything to avoid a new Greece - this time an Italy - crisis." The news saw the yield on the Italian 10-year government bond hit a four-year high as bond prices dropped again.

Bank exposure

The problem is that Italian banks own around €380 billion in Italian bonds. As those bonds lose value, the banks take losses and their capital buffers get weaker. In addition, French banks own more than €277 billion in Italian bonds while Germany has an exposure of some €82.5 billion. (On a related issue, bear in mind the mind-blowing exposure that Italian and Spanish banks have to Turkish debt which has also come under pressure this summer).

ECB backstop

So far, the European Central Bank (ECB) has been a backstop as it engaged in its own version of quantitative easing. However, the ECB’s Asset Purchase Programme (APP) is set to end this December and is now running at a rate of €15 billion per month, down from €30 billion previously. This means that the ECB is now buying less than 10% of Italian debt and this should fall to zero in 2019. All this is adding to concerns that, as Mr Junker alluded to, we could see another existential European crisis but many times the size as the one still affecting Greece.

Whatever it takes

But for now, the general feeling is that the situation is probably contained. Six years ago, ECB President Mario Draghi promised to do “whatever it takes” to preserve the euro and he’s been good to that promise. That could mean that the ECB’s Governing Council decides to extend its APP beyond the end of this year should a rout in Italian debt roil financial markets if Italy’s leaders continue to face down the European Commission (EC).

Showdown with the EC

The full budget will be scrutinized by the EC on 15th October and there’s a very real danger that it is rejected. Last week European Commission Vice President Valdis Dombrovskis said that Italy’s budget was out of line with the Euro zone’s stability and growth pact. Jean-Claude Junker has also promised a “tough stance” on the country. However, it’s worth noting that the European Union has, in the past, failed to punish multiple deficit breaches by several members including Germany, France, the UK, Spain, Italy, Portugal and Greece. Undoubtedly, a rejection by the EC would inflame the Euro sceptics within the Italian government and would lead to further market volatility.

Testing support

The EURUSD tested support around 1.1500 earlier today. But the euro subsequently bounced as Italian tensions eased this afternoon. That’s not to say that the single currency is out of danger and a retest of this support looks quite probable, especially given the market uncertainty ahead of EU budget scrutiny in just under a fortnight. A couple of closes below 1.1500 on an end-of-day basis could set up the EURUSD for a retest of the August low of 1.1300. On the other hand, if buyers come in now it’s also possible that we see a sharp short-covering rally. However, given the current EU-US interest rate differential and the ongoing political uncertainty in Italy, a move towards the upper band of the current range at 1.1800 looks unlikely for now.
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