- EUR/USD weakened on Wednesday, falling to below the key 1.1700 watershed
- Ongoing political risk in Italy is seen as one of a mix of factors which forced the exchange rate lower
- Further downside to the 1.15s is potentialy on the cards according to Credit Suisse
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Political developments in Italy appear to be coinciding with more weakness in the Euro.
On Wednesday, as the new prime minister of the populist coalition government, Guiseppe Conte was sworn in by Italy's president Sergio Mattarella, the Euro-to-Dollar exchange rate dropped to new lows in the 1.1670s.
Now speculation has turned to the composition of the new cabinet, its policy priorities and whether Italy's new finance minister will be the Euroskeptic octogenarian economist Paolo Savona.
Savona is an arch-critic of the Euro, arguing it would be better for Italy to return to the Lira, so his selection could spark more volatility and increase the risk of Italy withdrawing from the common monetary area.
"If Savona’s name were confirmed as the finance minister nominee, we see scope for Italian political risk to start having a wider impact on European assets," says Alvise Marino an analyst at Credit Suisse.
The formation of a coalition government in Rome which is set on a course at loggerheads with the European Commission in Brussels has already hit financial markets.
One of the coalition's proposals, to request that the European Central Bank (ECB) write off 250bn of Italy's 2.1tr in debt to give it the fiscal breathing-space to increase public spending and lower taxes, has caused a cliff-edge decline in Italian government bond prices and a sudden surge in the price of Italian credit default swaps (CDSs).
CDS's pay the holder if the government in question defaults on its obligations. The increase is reflected in the rising cost of insuring Italian government debt against default, illustrated below.
However, early fears that the collapse in Italian bond prices would spread to other EU members have now eased suggesting the crisis could be contained.
A comparison of Italian bond yields with much lower German bond yields (yields are the inverse of bond prices), with the same comparison made between Italian and Spanish bond yields, which are more vulnerable to contagion, should present two very different pictures, if the crisis was spreading.
Yet in actual fact both the Italian-German and the Italian-Spanish yield spreads show a similar spike after the coalition came to power, inferring that the impact of the Italian debt crisis has been no different in Spain to Germany and that there has been very little or no contagion from Italy into Spanish debt markets.
Many analysts saw Italian political contagion as the greatest threat to the Euro, and so a lack of evidence that there is any contagion could take the pressure off the single currency.
"USD strength continues. Yesterday EUR/USD once again eased by approximately 1 cent high to low. And no, what we are seeing in EUR/USD is not EUR weakness. Our currency indices are not indicating that. It is simply that the euro has been unable to appreciate any further for about one month. Therefore, it would be wrong to blame the low EUR/USD levels on the formation of a populist government in Italy," says Ulrich Leuchtmann, an analyst at Commerzbank.
However, Mathieu D’Anjou, Senior Economist with Desjardins suggests that it might not be through the 'contagion channel' that the Euro suffers.
D'Anjou argues that Italy is far from sparking the kind of Eurozone crisis we saw back in 2012; but there could be the chance that it impacts the Euro via European Central Bank policy moves.
"The situation in Italy is yet another reason for the European Central Bank to be extra cautious its taking action, which could extend the period of weakness for the Euro," says D’Anjou. Calibrating the impact on the Euro of the Italian political circus via the ECB route will certainly be harder to identify but appears to us be a valid argument for Euro underperformance.
Markets are expecting an announcement from the ECB this summer detailing when they will exit their quantitative easing programme; markets assume the exit date that will be set will be September. Any delay could certainly undermine the Euro.
"A Eurosceptic government at the head of the Eurozone’s third largest economy and renewed financial tensions are a reminder that Europe still has challenges to deal with, despite the more favourable economic environment," says D'Anjou.
The release of poorer-than-expected PMI activity data for the Euro-area on Wednesday morning provides another reason for the European Central Bank to pause for thought.
For Credit Suisse's Marino, European risks are a compelling factor in expecting underperformance in the EUR/USD.
"The deterioration in the preliminary May euro area PMI data, political risk in Italy and ongoing unease in EM space leave us unwilling to change course for now," he says. "The weak European data, in particular, complicates the fiscal equation for the periphery at a time when political risk is on the rise."
"We see a risk this could translate in more widespread negative impact on European assets, and see scope for ECB tightening expectations to come further under pressure ahead of the 14 June meeting," adds Marino.
Marino forecasts a continuation of EUR/USD weakness conditional on a confirmed break below 1.1717.
Downside targets begin with 1.1675 initially, followed by the November 2017 low at 1.1585.
The weaker Eurozone growth data is a major headwind for the Euro, according to Viraj Patel, an FX Strategist at ING Bank.
"In the absence of EZ economic data finding another gear this side of summer, the chances of a hawkish ECB-led rally in the single currency look pretty bleak," says Patel.
One supportive risk factor for the pair is the possibility of a dovish set of FOMC minutes on Thursday, May 24, "and these might may help EUR/USD consolidate above 1.17 – though Italian politics is likely to keep any upside broadly in check," says the strategist.
That Savona is set to be the new minister of Finance is not a done deal either, says Patel who mentions reports of Chicago Booth University's Luigi Zingales being considered for the position as well, an alternative selection which "could be mildly supportive for the EUR," he claims.
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