Italy Playing Game of Chicken with Market and European Authorities
The budget fight in Italy has raised risk premia there — seen through Italy’s rising bond yields. The chart below shows the spread between Italy’s 10 year government bond yield and that of Germany. The spread is elevated — around 300bps currently. By comparison, during the European banking crisis, the spread got above 500bps. This is one of the factors weighing on EURUSD currently. As the 10 year yield spread (Italy less Germany) widened, EURUSD weakened. (charts below)
Italy’s budget battle is ongoing. In late September, Italy proposed a budget with a deficit of 2.4 percent of GDP for the next three years. The spending would fund additional welfare spending, tax cuts and boost public infrastructure investment. On October 23, the European Commission (“EC”), in an unprecedented step, gave a negative opinion on Italy’s 2019 draft budget and asked that it be revised.
Italy has a populist, Eurosceptic government so the EC has to walk a fine line – both rejecting Italy’s budget while not giving the current government any additional Eurosceptic “ammunition”. Due to Italy’s high levels of debt – the highest in the European Union, the EC wants Italy to continue to cut its deficit.
Italy’s government has until November 13 to hand in a revised budget to the EC. Italy’s government, so far, has remained defiant. In a November 5 interview with the Financial Times, Italian Deputy Prime Minister Luigi Di Maio said that Italy’s budget plans wouldn’t change due to EU pressure. Instead, Italy’s government seems to think that the budget only needs to survive until the May 2019 EU Parliamentary elections. Italy’s government is hoping that more anti-austerity parties will be elected then, making the EU more open to fiscal loosening.
Meanwhile, Politico Europe is reporting that the EC will propose disciplining Italy on November 21 if no changes are made to the budget. EC can propose and launch an Excessive Deficit Procedure (“EDP”) against Italy. The EDP is a corrective action plan to encourage a member state to get its budget deficit under control. Failure to comply with the EDP can result in fines of up to 0.5 percent of GDP.
Of course, Italy may be pressured to revise its budget by the market if its rate spreads widen substantially further – a scenario that would negatively impact EURUSD.
As if the budget battle wasn’t enough, Italy’s economy failed to grow in the third quarter — real GDP growth came in at 0.0%, well below the Bloomberg consensus forecast. Moody’s downgraded Italy on October 19, cutting Italy’s credit rating to one level above junk status. On October 26, S&P cut Italy’s outlook to negative from stable but kept its debt rating at BBB.
Political Uncertainty Comes to Germany
In a somewhat surprising move, German Chancellor Angel Merkel announced on October 29 that she would not seek re-election as head of the Christian Democratic Union (CDU) and would step down as Chancellor in three years’ time. However, analysts are raising the issue that Merkel could be forced out as Chancellor sooner depending upon who the CDU chooses as her successor to lead the party. Political uncertainty in both Italy and now Germany is not good for EUR. The October 29 and 30 editions of the “FT News Briefing Podcast” discuss scenarios and implications of Merkel stepping down.
Eurozone Growth Worries
As Italy’s Q3 growth stalled, the Euro-zone’s Q3 growth came in below expectations at 0.2% Q/Q. Germany’s IFO business sentiment indicators deteriorated for their October readings. The chart below shows the slowing of Eurozone real GDP Q/Q% and the German IFO business expectations.
ECB President Mario Draghi at the October 25 ECB press conference acknowledged some slowing of economic data, saying “Incoming information, while somewhat weaker than expected, remains overall consistent with an ongoing broad-based expansion of the euro area economy and gradually rising inflation pressures.”
US economic growth, by comparison, is still strong. US Q3 real GDP came in at 3.5% q/q, ar following at strong 4.2% print in Q2. Nearer-term monetary policy, represented by the 2 year yield spread Germany less US in the chart below, favors the US. The Federal Reserve is actively hiking its policy rate (Fed Funds) whereas the ECB is focused on ending QE with a lag to when the first rate hike will occur. At the moment, this divergence between the respective central banks’ monetary policies is another factor weighing on EURUSD.
Favoring EURUSD Short Position
Italy deadlines and headlines will keep EUR on its backfoot in the near-term. Looking at recent positioning data, EUR shorts are moderate, suggesting that there is room to build on them. EURUSD has been ranging between 1.1500 and 1.1300. A break of 1.1300 support could see EURUSD move substantially lower. One could sell EURUSD on a break of 1.1300 or buy a 1.1000 3 month EURUSD put.
Looking at the other half of the trade, the USD, despite upcoming event risks in the US, including the mid-term elections, volatile equity markets and China negotiations, the USD retains its safe-haven status – it is a flight to quality for risk reduction elsewhere such as EM. Those factors should keep USD somewhat bid vs. EUR.