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Euro feeling the heat

By David Morrison  |  09/10/2018 14:30
”treasury

There’s a conflagration of factors weighing on the euro, including rising US Treasury yields, the Italian budget stand-off and the Bavarian state election this Sunday

Yesterday the EURUSD broke and close below support around the 1.1500 area. This morning the sell-off accelerated in a move which took the euro back towards 1.1400, raising the possibility of a retest of the mid-August low around 1.1300. This price action follows on from last week’s shallow break of 1.1500 which then saw rebound. However, that rally reversed on Monday, and this morning saw the selling pressure build on the single currency.

Italy remains on focus

There are several reasons for euro weakness. Firstly, the new Italian coalition government looks set on having a showdown with the EU. Just over a week ago, Matteo Salvini and Luigi Di Maio, joint Deputy Prime Ministers and leaders of the Northern League and 5-Star parties respectively, announced a budget plan which would see the country’s budget deficit balloon to 2.4% of GDP for the next three years. They subsequently revised their numbers down a touch, but the new budget would still leave debt/GDP at 2.0% in 2021.

“No Plan B”

The European Commission has said that this is a clear breach of what Italy was asked to do over the summer – that is, cut its structural deficit every year until it is in balance. But Italy’s government is adamant that they are determined to fulfil their election promises and that there is “no Plan B”. The two sides remain at loggerheads with the European Commission set to approve or reject the budget next week. In the meantime, Italian bond yields have soared to four-and-a-half-year highs.

Debt burden

The problem is Italy’s debt burden. As pointed out in an article by Mark Cudmore on Zero Hedge: “no country in history that doesn’t control its own currency has ever had such a large debt pile. This situation is unprecedented”. On top of this Italy’s debt-to-GDP is more than 130%, second only to Greece’s 180% amongst Euro zone members. But the Italian economy is around ten times the size of Greece’s. There’s also the issue of ‘Target2’, designed to settle cross-border payments across the Euro zone. 

Target2

Under ‘Target2’, Italy owes the European Central Bank (or Germany really) around €480 billion. However, this has been described by one economist (whose name, regrettably I can’t remember) as a settlement system without a method of settlement. Italy would only have to repay the money if it left the Euro zone and adopted its own currency. But adding in this liability to Italy’s debt load takes the country’s debt/GDP ratio to over 160%.

Calming markets

But this is an issue for another day. Despite the prospect of a lots of shouting and shoving between the European Commission and the Italian leaders, the two sides know what’s at stake and are likely to try and assure markets that Italy’s debt burden will ease in the years ahead, calming investor fears. If so, then that should see Italian bond yields pull back and will take some pressure off the euro. However, investors will still question just how Italy is going to be able to slow down its ever-growing debt pile. Economic growth is tepid. Meanwhile, Euro zone inflation isn’t nearly high enough to make much of a dent, particularly as the ECB looks to end its quantitative easing programme at the end of this year. The only other option, outright default, doesn’t look like a ‘market-calming’ option. So, it could be that any rapprochement between the EU and Italy that settles the market may be short-lived. Certainly, risks remain.

Bavarian elections

There’s another issue which is weighing on the euro this week. This Sunday sees Bavarian state elections in Germany where there’s real possibility of a redrawing of the political map. The problem is that the Christian Social Union (CSU), which has been the dominant force in Bavarian politics since its formation in 1945, is haemorrhaging support. It won 48% of the vote at the last election in 2013, but the latest polling suggests this could fall to a little as 33% this time round. The CSU is the long-term coalition partner of Angela Merkel’s Christian Democratic Union (CDU). But there was a rift between the two this summer concerning immigration which will be a major factor in Sunday’s election. A strong performance from the right wing, anti-immigration and Eurosceptic AfD could really roil markets, although polls suggest that the Greens should also do well.

Treasury yields

Finally, dollar strength is also adding to the euro’s woes. Last week’s sharp spike in US Treasury yields rattled risk assets and saw the greenback surge higher. Yesterday’s Columbus Day break meant that the US bond market was closed. However, any hopes that Treasury yields would soften today were dashed when the 10-year rallied to 3.26%. It had pulled back a touch by the time the US stock market opened and the EURUSD recovered some lost ground. Nevertheless, traders remain on guard.
 


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