Euro Exchange Rate: Italy Weighs, but Beware Recovery in Single-Currency

Above: Jean-Claude Juncker. Juncker warned Italy risks a Greek-style crisis with its current budget plans © European Union, 2018 / Source: EC - Audiovisual Service / Photo: Etienne Ansotte

- E.U. set for showdown with Italy over budget plans

- Euro amongst worst performers on FX market

- But one analyst tells us markets are over-reacting

The Euro exchange rate complex retains a soft tone owing to ongoing anxieties relating to Italy and the country's desire to run a budget that would boost its debt pile to an extent that violates European Union rules.

The latest set of market concerns were triggered by media reports suggesting the E.U. will reject Italy’s budget proposal, leading foreign exchange analysts to warn the currency is likely to remain pressured near-term.

“Our assessment so far from what is currently emerging is that this is not compatible with the Stability and Growth Pact,” says the Vice President of the European Commission Valdis Dombrovskis.

Eurozone states are bound by rules that state a country's budget deficit cannot run beyond 3% of GDP; the Italian coalition government has meanwhile proposed a 2019 deficit that is, at 2.4% of GDP, while it is below the 3% threshold it is still three times the previous administration’s target.

The overall debt of Italy currently stands at 131% of GDP, which is the second biggest in the eurozone after Greece, the EU ceiling is 60%.

At a meeting of finance ministers in Luxembourg on Monday, Bruno Le Maire, France’s economy minister, stressed that the economic fate of members of the Eurozone was linked, saying the Eurozone’s budget rule book was meant to protect countries from higher borrowing costs.

European Commission head Jean-Claude Juncker meanwhile warned of a Greek-style crisis when discussing Italy’s budget. The E.U. meet on the 15th October to decide on their actions in this regard.

"FX markets are back to a mild 'risk-off' mode, with EUR leading the move as Italian budget issues continue to weigh," says Robin Wilkin, a foreign exchange strategist with Lloyds Bank in London. "Italian 10-year yields have accelerated higher, dragging German 10-year yields lower and with them the EUR."

Above: The Euro is vying for the title of worst-performer in the G10 currency complex for the past week.

The Euro-to-Pound exchange rate is quoted at 0.8878, well off the previous week's high of 0.8996. The Euro-to-Dollar exchange rate is quoted at 1.1522, having been as high as 1.18 in September.

According to the European Commission's Fiscal Compact, Italy must bide by a requirement to have a balanced budget rule.

The "Stability and Growth Pact", adopted in 1997, states that a government's debt cannot be higher than 60% of GDP, and the deficit may not exceed 3% of GDP.

If a country does not manage to keep its finances within these limits, it risks fines and being forced into prescribed economic measures set out by external authorities.

Such recourse would surely undermine the structure of the Eurozone and European Union, hence the current market jitters concerning the trajectory of Italy's finances and its relationship with Europe.

As of yet, it appears the Italian government is unwilling to step back from its current plans, ensuring a destabilising showdown with the E.U. is possible.

"The Italian government seems adamant about not changing its 2.4% deficit target, which suggests the long-feared showdown with the EU may well play out in the coming weeks. The Euro remains on the back foot in the midst of this, surrendering ground across the board amid an exodus of capital from Italian bond markets recently," says Marios Hadjikyriacos, Investment Analyst with brokers XM.

Concerning the outlook for the Euro, the near-term outlook is subdued owing to the current bout of nerves.

There is however certainly a sense of wait-and-see with currency markets not yet willing to pull the trigger and initiate a sharp sell-off in the Euro.

Indeed, the single-currency remains within the bounds of medium-term trends and one analyst suggests the potential for a rebound in the currency is possible.

"In our view, worries about Italy’s fiscal outlook are overblown meaning EUR has scope to recover some of its recent losses. Italy has been running a primary budget surplus (overall budget minus interest payments) of over 1% of GDP since 2012 which is consistent with a modest improvement in the debt-to-GDP ratio. The European Commission is expected to give its formal opinion on Italy’s fiscal plan by 15 October," says Elias Haddad, a foreign exchange strategist with Commonwealth Bank of Australia.

We therefore look for a comeback in the single-currency should market attention move away from Italy, particularly as much of the news concerning the budget plans are well known and therefore largely already absorbed into current valuations.

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