Eurozone uncertainty rears its ugly head


Another week on and another Eurozone crisis appears to have been averted (for the time being). Last week started with Italian bond yields rising sharply (the yield on the 2-year bond rose to 2.76% its high level since August 2012 while EURUSD fell to 1.1510) amid concerns that another general election could descend into another referendum. However, shortly after the leaders of the 5 Star Movement and the League joined forces in a second attempt to form a government, an agreement was reached and Guiseppe Conte was named the new Prime Minister.

 

Conte is a little-known law professor who belonged to neither party and was not elected so was a somewhat surprising choice to lead the coalition. However, his pledge to improve the quality of life of all Italians was well received by the markets prompting the 2-year yield to fall back to 0.82% and EURUSD to recover back to 1.1750 this morning.

 

Chart – Italian 2-year government bond yield

 

 

Source – Bloomberg

 

As if that wasn’t enough to give the world’s financial press something to write about, conservative Spanish PM Mariano Rajoy was ousted as Prime Minister in a vote of no confidence and replaced by Pedro Sanchez, the leader of the opposition socialist PSOE party. Sanchez vowed to address the pressing social needs of the Spanish people after years of austerity under Rajoy’s conservative leadership. Spanish yields reacted in a very similar manner to their Italian counterparts on reignited concerns of a Eurozone break up before a state of calm was restored.

 

In our opinion, the idea of a state of calm being restored, dramatically undersells the events of last week. In fact, whether calm was restored or not isn’t really the key point – if anything it’s just short-term noise. What’s more important to recognise here is that the vote against the establishment continues to grow. As we saw with the French, Dutch and German elections, we haven’t yet reached the point where the current regime has run its course, but longer term, the events of last week add confidence to our long-term view that the Eurozone will break up in due course.

 

What does this mean for our euro view?

 

As regular readers will know, we have held a long term bearish view on the single currency for a number of years and that has not changed. However, just as the victories of Macron and Rutte showed last year, the events of last week confirmed that the Eurozone isn’t quite ready for change yet. This should offer some support to the euro in the short term at least.

 

Of greater influence in the near term, is the expected actions of the ECB. After a slew of weaker than expected data releases in May, the probability of Draghi announcing a rate hike before the latter stages of 2019 is looking increasingly remote and this has been reflected in the general weakness of the euro (primarily against the dollar) in recent months. Meanwhile, the market is now pricing in rate hikes from the Fed both next week and again in September with a very high level of confidence.

 

Given what’s now priced in, coupled with the severity of the recent market moves, there is increasing risk of a correction in the short term (although we see this being driven primarily by a wobble in the USD rather than a surge in the euro). Ultimately though, we expect the dollar to remain the dominant force in the currency markets helped by yield differentials. 

 

    

Author: Marc Cogliatti

 

 



 

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