Pound a "Safe Haven" for Euro Holders if Italian and German SPD Votes Goes the Wrong Way

Modified: Wednesday, 28 February 2018 12:22 GMT
Written by: James Skinner

Pound Sterling could be among the beneficiaries should the Italian election trigger a “market unfriendly” outcome say J.P. Morgan.

Italians go to the elections on Sunday, March 4 and should voters deliver a “market unfriendly” outcome, the Euro could decline while Sterling could be a winner.

Those currencies tipped to benefit in such an event are the traditional safe-havens such as the Japanese Yen and US Dollar.

But analysts at J.P. Morgan reckon Sterling could find itself a relative “safe haven” too. The reasoning for the call is the Pound is still some 13% weaker against the Euro this February than it was the day before the Brexit vote in 2016 which trigger sizeable declines.

An unfavourable outcome in Italy on Sunday would even up this balance of perceived risk a bit, benefitting the Pound relative to the Euro and J.P. Morgan cite the example of previous bouts of risk averse trading in the Eurozone.

Ahead of the French election in 2017 the Pound-to-Euro exchange rate rose towards 1.20 and swiftly retreated following the pro-European outcome delivered by the Macron victory.

Above: Sterling-Euro benefited amidst nerves ahead of French elections in 2017. Once risk cleared, the Euro strengthened notably.

“GBP behaved as an unlikely albeit intuitive safe-haven as investors took the view that whatever threatened the unity and integrity of the Euro area justified less of an idiosyncratic Brexit risk premium in GBP,” says Paul Meggyesi, vice president of global currency and commodity strategy at J.P. Morgan.

“We suspect a similar pattern would play out this time either on an MS5-led non-mainstream government or a hopelessly hung parliament that necessitates a second election,” says Meggyesi.

Indeed, it is not just elections in Italy to worry about as Germany is also due to see some risks with the left-wing SDP party voting on whether or not to join a coalition with Angela Merkel's CDU. "The EUR cannot entirely avoid political risks in Germany and Italy. While not a game-changer for the medium-term uptrend, the lingering event risks offer a great reason to take profit on a well-populated trade," says a strategy note from global investment bank TD Securities.

Most analysts, J.P Morgan included, suggest any market fallout to the Euro from an adverse outcome Sunday should be much more limited in severity than the Brexit fallout, given the Euro area economy is in rude health and few really expect Italy to actually abandon the Euro or to divorce with the EU.

The concern for markets is that, at best, a troublesome Italian government slows the pace of economic reform in the Eurozone. It might also become less cooperative in relation to the migration crisis and, at worst, it could put the idea of a referendum on the Euro back on the table.

Likewise with Germany, any failure by Merkel to secure a deal with the SDP could put further European integration on hold.

At the very least, the shot of uncertainty posed by adverse outcomes to both or either events is non-negligible, and currencies hate uncertainty.

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Five Star Success is Key Risk to Watch in Italy

Almost all parties vying for electoral support have made pledges that will place Italy on a collision course with Brussels over public spending and the nation’s budget deficit.

Italy has a complex electoral system although it is commonly thought that a party or coalition will need at least 40% of the vote to wield a majority in both upper and lower houses. All parties and alliances fell short of this threshold in last week’s opinion polls.

The Five Star Movement, Italy’s largest political party and a growing anti-establishment force, has pledged to renegotiate European rules on budget deficits that have demanded years of crippling austerity.

It has floated the idea of a referendum on Italy’s continued use of the Euro in the event that the negotiation fails, making Five Star the currency market’s idea of a nightmare government, although this is a step backward from an earlier pledge to proceed directly to a referendum after election.

The EU has said repeatedly that the Euro is the currency of the union and it cannot be abandoned without a nation also abandoning the EU.

J.P Morgan says there is only a lowly single digit probability of Five Star winning a majority, which strategists at the bank estimate would produce a fall in the Euro-to-Dollar rate to around 1.20, down from 1.2264 Tuesday.

“We attach higher odds, 9%, to a complete stalemate after the election that necessitates fresh elections, but the EUR fall-out from that should be more limited, perhaps confined to a couple of cents and quickly overshadowed by underlying fundamentals,” Meggyesi writes, in a recent note.

Five Star was outgunned in the opinion polls last week by an alliance of parties including former PM Silvio Berlusconi’s Forza Italia, Lega, Brothers of Italy and Us with Italy. These parties have entered a pre-election alliance that commanded the largest share of electoral support in the latest opinion polls.

However, they have also campaigned heavily on an anti-austerity as well as anti-migration ticket, and lacked the magic 40% number in last week’s polls.

“Even though EUR correlations would jump on an election upset in Italy, investors should still be selective in setting hedges as EUR is not expected to collapse on a broad-basis and we still expect a reasonable differentiation in the performance of individual EUR crosses,” Meggyesi writes.

Europe and the Euro’s greatest hope of being able to avoid a disruptive outcome Sunday is a victory for the ruling PD, led by former PM Matteo Renzi and his alliance of centre-left parties including More Europe a pro-European party, Lista Insieme and Civica Popolare.

However, opinion polls have shown support for the PD slumping from 30% in December 2016 to around 21.9% just last week. Even when votes for the other smaller alliance partners are thrown in together, its total share of the electorate is still below that of Five Star as a standalone party.

What to Trade

“We highlight EUR/JPY and EUR/GBP as the crosses with most downside potential on a market-unfriendly result,” Meggyesi concludes, referring to the Euro relative to the Japanese Yen and the Euro relative to Pound Sterling.

Barclays analysts also flagged buying the EUR/JPY as a 'trade of the week' as it is tipped to benefit on an Italian upset.

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Get up to 5% more foreign exchange by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here.