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Comback Kid: Euro Advances on Pound Sterling as Markets Eye Resolution to Italian Political Impasse

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- Five Star and Liga reported to be attempting to form a government again

- Euro bid higher as markets take stock of situation

- But, one analyst says Euro will continue to struggle as political concerns will inevitably flare up again

Salvini

Above: Liga leader Matteo Salvini will try once more to form a government with partners Five Star © European Union - European Parliament, reproduced under Creative Commons licensing

The Euro retains the gains made in the mid-week session, having been in the doghouse at the start of the week as market tensions concerning Italy recede. But we are being warned by a number of analysts there is a good chance that the Euro's improvement could be a mere counter-trend relief rally and more nerves stemming from Italy should be expected.

The single currency is outperforming the Pound, US Dollar, Yen and Swiss Franc as investors judge the mood to be 'risk-on' in global markets amidst signs that Italy's Five Star and Liga parties are to take another crack at forming a coalition government.

Investors judged the mood to be 'risk-on' in global markets after the Italian president, Sergio Mattarella, granted Italy’s two main parties more time to form a government in an attempt to stave off a snap election.

Such an outcome would put to rest 1) fears of months of protracted political limbo in the Eurozone's third-largest economy and 2) fears that Liga and Five Star will grow their vote share in another election as Italian voters push back against perceived establishment meddling, thus emboldening their anti-EU agenda in any subsequent government.

"The market decided that the big fear over Italy was overdone yesterday after the country successfully completed 5- and 10-year bond sales. Both auctions were oversubscribed, with higher bid-to-cover ratios than at the previous auction," says analyst Marshall Gittler with ACLS Global.

"The FX market continues to be driven by Italian and Spanish political developments. However, the risk-off sentiment has eased somewhat as investors take a step back to re-evaluate the situation," says Arnaud Masset, an analyst with Swissquote Bank, based in Gland, Switzerland.

The Pound-to-Euro exchange rate is seen trading back below 1.14 at the time of writing having been as high as 1.1496 earlier in the week; this level represents a monthly best for the currency pair.

The Euro is meanwhile back above 1.17 against the US Dollar, up from a monthly low set in the previous 24 hours at 1.1518.

"It would be fair to expect some relief for the Euro. Nothing bad has actually happened yet and there are likely to be calming words from the protagonists in Rome," says a note from the dealing desk of global payments specialists Moneycorp.

Carlo Cottarelli, a former IMF economist, had been close to putting together a technocratic and unelected government, after negotiations to form a coalition between the Five Star Movement and the League was effectively blocked by the country's President over the weekend who balked at the coalition's favoured anti-Euro candidate for the job of finance minister.

Cottarelli has since been quoted by Italy’s national news agency as saying that new possibilities had emerged "for the birth of a political government" and markets liked the suggestion that an end to the uncertainty was in fact possible.

Cottarelli says he had decided to “wait for further developments”.

Sources within Five Star indicated that they were willing to back down on their previous demand that Paolo Savona, a staunchly anti-euro economist and former banker, should be made economy minister in the new government.

This is a market-friendly outcome because 1) fears of months of protracted political limbo in the Eurozone's third-largest economy will be put to rest and 2) fears that Liga and Five Star will grow their vote share in another election, thus emboldening their anti-EU agenda in any subsequent government.

However, longer-term doubts over the Euro's ability to advance remain, with markets fearful that the question of Eurozone politics will only flare up again in the future.

"As recently as 18th May I predicted that the Euro might push aside the Dollar as the dominant leading world currency. However, in the meantime fears about a rekindling of the Eurozone crisis have returned. That reduces the likelihood of such a development considerably – well beyond the current crisis in Italy," says analyst Ulrich Leuchtmann with German lender Commerzbank.

Leuchtmann argues the Italian political situation shows the Eurozone is inevitably prone to crisis:

"They voted for euro-skeptics and euro-opponents despite the fact that GDP growth in Italy was ok, the unemployment rate was falling (albeit slowly) and private consumption was rising significantly. The fact that the Eurozone emerged from the last crisis without long term damage to the real economy clearly does not help to overcome the fact that the currency area is prone to crisis."

Jay H. Bryson, Global Economist, with Wells Fargo says investors should be prepared for financial volatility stemming from Italy to last for months:

"In our view, it is too early to make confident predictions about how the situation in Italy will ultimately evolve. Much will depend on political decisions that are made in coming months, not only in Italy but in other European countries as well. Readers should be prepared for more volatility in coming months as domestic and foreign actors in the Italian saga make their decisions."

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How Italian Politics Arrived at this Point

The two big winners in Italy's recently-held general election were Five Star and Liga; they attempted to join forces but abandoned efforts after the president vetoed their choice of finance minister.

Mattarella said he could not appoint the Eurosceptic Paolo Savona to the post, citing concern from investors at home and abroad.

But a Five Star source told Reuters on Wednesday morning that an attempt was being made to find "a point of compromise on another name" for finance minister.

The rare move by the president to veto the choice of finance minister sparked fury from both populist parties, who say they will reject Cottarelli's nomination in parliament.

The chance of the anti-establishment parties growing their vote and towing an even harder line against Brussels is only reinforced by any views that the establishment is working against the will of the Italian people.

A top Eurocrat drew criticism earlier in the week by saying money market chaos in Italy will teach voters not to back populist parties.

“My expectation is that the coming weeks will show the development of the markets, government bonds and the economy of Italy will be so far-reaching that this will be a possible signal to voters not to vote for populists on the right or left,” said EU Budget & HR Commissioner Guenther Oettinger.

Sensing the danger in such utterances, both Jean-Claude Juncker and Donald Tusk slapped Oettinger down, with Tusk saying "my appeal to all EU institutions: please respect the voters. We are there to serve them, not to lecture them."

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