Catalonia 'Crisis': Euro at Risk of 5% Fall on 'Yes' Vote in Impending Referendum

• FX market quotes at last update:
• Pound-to-Euro exchange rate: 1 GBP = 1.1400 EUR
• Euro-to-Dollar exchange rate: 1 EUR = 1.1778 USD

“If the Catalonia referendum goes ahead we expect this to be a disruptive event for the Euro, with the potential for a sharp decline of up to 5% initially” - Kathleen Brooks at City Index.

The German federal election outcome has dented sentiment towards the Euro and reminds us political risk still has the ability to move the single-currency.

The British Pound has risen to a ten-week high against the Euro just above €1.14 as a result while the Dollar has pushed the EUR/USD down to $1.1836.

Angela Merkel’s bitter-sweet victory in the German election Sunday, which saw the CDU bleed support to smaller alternative parties who threaten a shakeup of the established order in Berlin, was the headline event throughout the Monday session.

Merkel is expected to form a new coalition, but the composition of the Government could delay an imminent German-French push for further Eurozone reform. But more importantly for investors, we are reminded that politics has not gone away as a potential anchor for the Euro.

“The surprising gains by alternative parties and poor performance of the centre establishment parties in Germany’s election subtly reinserts politics into the debate over the EUR’s value,” says Marvin Barth, FX Strategy Research at Barclays in London.

Barth observes most of the EUR’s gains have come since the French election, with many pointing to the reduction in perceived political risks to the European Union and Eurozone as important contributors to the common currency’s ascent.

"Since the French elections, we’ve noted that the EUR may have been playing the role of a ‘political haven’ – especially when taking stock of the political risks plaguing the likes of other G4 currencies (namely USD and GBP). However, the return of the ‘populist voter’ in a European election is a reminder that political risks haven't completely abated for the Euro," says Viraj Patel, an analyst with ING Bank N.V. based in London.

Catalonia

For this reason some are now sitting up and looking out for the next potential flare-point -  Spain’s Catalonia region where seperatists are pushing for independence is eyed as one potential risk. 

"The downside risks to the eurozone are primarily linked to political events; the deteriorating security policy situation globally, questions about Russia and Turkey’s political future, the instability in the Middle East and the referendum in Catalonia on 1 October,” says Robert Bergqvist, Chief Economist at Scandanavian lender SEB.

The unofficial referendum on Catalonian independence is due on October 1, and some analysts are forecasting further potential losses for the common currency in the future as nerves over this potentially disruptive event grow.

“The bigger risk to the Euro is unlikely to come from Germany, but instead could come from Spain where the Catalan region is planning to hold an illegal referendum on independence on 1st October,” says Kathleen Brooks, research director at City Index.

Thus far, the risks associated with the Catalonia referendum have been low-key with little angst being seen on currency markets but commentators are increasingly referring to the matter as an impending 'crisis' for Spain.   

But, political tensions in Spain are building with campaigners intend to hand out more than one million ballot papers to support an independence referendum that has already been prohibited by the country’s constitutional court.

Spanish authorities have made arrests, seized ballot papers and sought generally to obstruct the October 1st referendum planned by the regional government in Catalonia, a wealthy province of Spain.

Spain’s attorney general has refused to rule out the possibility of arresting the Catalan president, as the region’s pro-sovereignty government prepares to defy Madrid by holding an independence referendum on Sunday.

There are reports that the uncertainty and increasing unrest are impacting on businesses. "Decisions are not being taken and investments are already being postponed," says Borja García-Nieto, the chief executive of local private equity group Riva y García. "This is already bad for the economy, and the problems are potentially just starting."

“The referendum has been deemed illegal by the central Spanish authorities, yet this has seemingly emboldened the separatist supporters,” says Brooks.

Antonio Barroso, deputy director of research at Teneo Intelligence says "a more untied pro-independence movement increases the risk of an upgraded secessionist challenge. This could take different forms, which go from a unilateral declaration of independence to adopting further steps to 'disconnect' Catalonia's legal order from Spain's,"

October’s referendum in Catalonia will be the second such vote in a little over three years after an earlier 2014 campaign for independence was hampered by low turnout and similarly ruled as illegal by Spain’s constitutional court.

At the time of writing, Sunday's vote is still going ahead.

Oliver Jones at Capital Economics says "if the outcome is a 'yes' vote and a unilateral declaration of independence follows, the destabilising effect on the economies of Catalonia and Spain could be very large."

The exact outcome of a yes vote is hard to quantify and therefore predicting the currency reaction is tricky.

However, City Index's Brooks has a figure for potential Euro decline.

“If Catalonia votes for independence, even if the vote is deemed illegal, then it could put pressure on Madrid to allow the people of the region to have a legal vote, which could increase the chance of a break up of Spain,” says Brooks.

Brooks notes how the British Pound fell more than 6% during the three months leading up to the Scottish independence referendum in 2014, even though Scottish independence was generally seen as a low probability event.

"Overall, referendums in recent years have not been good news for a currency... if the Catalonia referendum goes ahead we expect this to be a disruptive event for the Euro, with the potential for a sharp decline of up to 5% initially in the single currency if the separatists win."

Most analysts do not yet place Catalonia as a high-risk issue for the Euro yet, rather they are looking towards the Italian elections, due in early 2018.

What the German polls have taught us is that the electorate are not as content with the status quo as many in the markets had assumed.  

“Political risks haven't completely abated for the Euro – especially with the spectre of the possibly more contentious Italian elections looming in early 2018. This could well be a concern for medium-term real money investors,” says ING Bank’s Patel.

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What’s in it for the Pound?

The British Pound could meanwhile benefit from any political instability in the Eurozone, as it has done in the past.

Brexit remains a key concern for domestic politics, but Theresa May’s speech on Brexit delivered in Florence on September 22 appears to have injected a sense of cautious optimism regarding the outlook.

So on relative terms, the UK is seeing improved political risk sentiment, while the Eurozone has seen a deterioration.

“With German politics in a state of flux and US politics increasingly fraught, suddenly the UK looks a bit of a stable safe haven after Mrs May's speech on Friday. Although it hasn't unlocked doors, it’s been seen as a step in the right direction away from the likelihood of a hard Brexit," says Jim Reid, Strategist with Deutsche Bank.

The Pound has hit a ten-week high against the Euro over recent hours, and further gains cannot be ruled out:

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