Italian Election Outcome Puts Euro's Gains on Hold, for Now

The reaction in FX markets to a eurosceptic shift in Italy so far has been muted, as investors await more clarity on the composition of the next government.

The result of the Italian parliamentary election appears to be a hung parliament, as expected.

Anti-establishment parties have done well with both the Five Star Movement and Northern League registering strong gains, however none of the three major political blocs seem to be able to secure an outright majority.

At the time of writing, the Five Star Movement was projected to get around 31% of the votes and the Northern League around 19%, whereas the PD party's result disappointed with 20%.

Above: The Five Star Movement is to be the largest party in Italy's parliament © Vetralla5Stelle, reproduced under CC licensing

"The outperformance of the Northern League alongside the Five Star Movement has created some additional downside risk for the Euro. The possibility of some form of alliance between the Northern League and Five Star Movement could put Italy on a less favourable course, which could increase tensions with the EU and make it more difficult to pursue closer integration," says Lee Hardman, a currency analyst with MUFG.

At this stage it is difficult to say which party will get the mandate by the president to form a new government, but overall a grand coalition or centre-right coalition together with some smaller parties still seems most likely.

Anti-Euro politician Mario Salvini is a front-runner for post of Prime Minister © European Union / European Parliament, reproduced under Creative Commons licensing

At the time of writing, the Northern League's Matteo Salvini says his centre-right bloc appear to have the votes to push and form a government.

Speaking following the vote, Salvini told reports that he believes the Euro "is a bad currency" and is "destined to fail" confirming to markets that the next government could deliver a decidedly anti-Euro flavour.

Salvini is part of a right-wing bloc that won the most votes, but crucially the bloc did not secure the requisite 40% to take full control of the legislature.

"Euro strength could be halted until more clarity comes to light," says Antoine Lesné, head of EMEA strategy and research for SPDR ETFs at State Street. "Despite the recent toning down of anti-euro rhetoric, this is a blow to the strong consensus that the common currency has been enjoying of late."

Even in the case of a euro-sceptic coalition of Five Star and Northern League emerging, analyst Aila Mihr at Danske Bank says the actual euro exit risk is low.

"However, such an outcome would still be the most adverse one for markets, given the combination of reform roll-back and significant fiscal easing, which could bring Italy's debt woes quickly back into focus," warns Mihr.

The reaction in FX markets to the eurosceptic shift in Italy so far has been muted, with Danske Bank telling clients at the start of the new week that investors await more clarity on the composition of the next government.

EUR/USD trades still around the 1.23 level at the time of writing and the muddy outcome "should keep the cross in the recent range, in our view," says Mihr.

The Pound-to-Euro exchange rate appears to be stuck at levels seen in the previous week around 1.12 and a stable Euro should mean we could see the exchange rate continue to tread water.

MUFG's Hardman agrees that it remains a case of wait-and-see for traders in the near-term as 5 Star and the Northern League will struggle to implement their shared policy agenda. "Indeed, it is often a lot easier to talk the talk than to walk the walk. In these circumstances, it is reasonable for market participants to wait for further political clarity at the current juncture."

Behind-the-scene coalition negotiations are likely to begin in earnest despite the inconclusive result.

The next important date on the election agenda is 23 March, when both houses of parliament will come together for the first time and speakers of the houses are elected, which is a necessary precondition for President Sergio Mattarella to start the formal consultation process aimed at forming a new government.

"After a deal is found, the new government has to secure a confidence vote in parliament, leaving us to conclude that it is unlikely that we will have a new Italian government in place before May or June this year," says Mihr.

Should renewed coalition building efforts fail, new elections held in the second half of 2018 cannot be ruled out either argue Danske Bank.

Events in Italy follow the final conclusion of coalition wrangling in Germany after the SPD party voted over the weekend to back Chancellor Angela Merkel in government. So it's a case of one period of uncertainty being wrapped up, just as another period opens up somewhere else in the Eurozone.

"The news flow that emerged over the weekend seemed to suggest that some-where in Europe there will always be an issue. If a government is finally being formed in one capital then problems arise in the next one. Who would blame the FX market for wishing Europe could have a more centralized governance structure? At the same time the political difficulties also illustrates that a way towards any new governance structure would be quite bumpy," says Ulrich Leuchtmann, an economist and foreign exchange strategist with Commerzbank.

Leuchtmann notes the euphoria about the French President’s European initiative supported the Euro last spring but, "this euphoria is likely to crumble".

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