Risks over Italian Budget Keeps Euro Exchange Rate Complex on Back Foot

Image © Stadtratte, Adobe Stock

- Italian politicians start discussions on shape of budget

- Could result in dust-up between Rome and Brussels

- Euro yet to show any major concerns, but this could change

Italian politics are increasingly a focus for financial markets as the country's young government looks to set out their new tax and spend plans.

The first budget to be set by the coalition government is being eyed as a potential flashpoint with Brussels; there is a rulebook guiding spending for Eurozone countries in order to try and establish the fiscal unity required to make the currency union work.

Italy's political leaders begin discussing the 2019 budget in earnest on Tuesday with investors monitoring for signs of just how far they'll push the European Union's budget rules.

A breaking of rules should ultimately be met with some form of sanction by the EU.

Both wings of the coalition government have committed to expand Italy's debt pile in order to deliver on their respective campaigning pledges.

The budget will likely contain both tax cuts and a universal basic income according to Finance Minister Giovanni Tria said.

Basic income for the poor is a measure strongly backed by the Five Star Movement, while governing coalition partner, the League, promised voters a reduction and simplification of tax brackets.

Senior officials from the League, the junior partner in the ruling coalition, are due to meet with their leader, Deputy Prime Minister Matteo Salvini, for an initial assessment of the policies they will include and their impact on the public finances, one of the officials said, asking not to be named discussing a private meeting.

There are concerns for Italy's fiscal stability owing to the prospect of surging debt levels. Over the weekend Fitch affirmed Italy’s sovereign rating at BBB, but revised the outlook to negative from stable.

Fitch expects a degree of fiscal loosening that would leave public debt more exposed to potential shocks and it said that the downside risks to their fiscal forecast have increased since the last review in March.

"The Euro has still managed to hold the line near to 1.16, but caution is set to continue, preventing a more sustained rally back above 1.17 and probably keeping the common currency on a relatively sluggish tone for the rest of the week," says Roberto Mialich, FX Strategist with UniCredit Bank in Milan.  

Italy on Collision Course with EU over Budget Deficit⁰ https://t.co/LZ5DIuINLz pic.twitter.com/GILne9511t

— The Voice of America (@VOANews) September 3, 2018

Financial markets are clearly anticipating some dust-up between Italy and Brussels with a clear trend being witnessed in an ongoing adjustment higher for yields on Italian government bonds.

The Euro is lower against both the Dollar and Pound at the time of writing: The Pound-to-Euro exchange rate is quoted at 1.1092 and the Euro-Dollar rate at 1.1558, half a percent lower than where it opened the day.

"The Euro needs to cast off Italian budget concerns, trans-Atlantic trade tensions, and see better growth and (significantly) higher Bund yields before we a break higher is likely. For now, drift is the most we can expect," says analyst Kit Juckes with Société Générale.

It has resulted in yield spreads between Italian and German government bonds re-widening back out towards levels last recorded during the eurozone sovereign debt crisis.

"The pricing in of a more elevated Italian political risk premium is already well advanced," says Lee Hardman, currency analyst at MUFG in London, therefore the prospect of further moves might actually be limited.

Hardman expects market participants remain nervous ahead of the upcoming release of the coalition’s first budget in the coming months.

But, "the potential for an unfavourable outcome is already well anticipated as evident by the recent sharp move higher in yields," adds Hardman.

Of course, the Euro represents a wider community, therefore the ability of Italy - the area's third-largest country, to move the single-currency is up for debate.

Hardman argues the Euro has become less sensitive to Italian political risk, but he warns the recent resilience may not last.

It is noted that the broader trade-weighted Euro declined by around 2-3% in the months following the Italian election but has remained more stable in recent months, even as the Italian political risk premium has re-widened.

"Recent price action has provided support for our view that further downside for the Euro should prove limited. Negative developments in Italy would have to escalate significantly to undermine financial stability in the eurozone and open the door to a sharper correction lower for the Euro," says Hardman.

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