EUR/USD: There is Turbulence Ahead but Risks are to the Upside into Year-end say Credit Agricole

© European Central Bank

The Euro still faces a turbulent few weeks ahead as the Italian budget saga draws to a close but beyond this period, risks for the Euro-to-Dollar rate are tilted toward the upside into year-end, according to analysts at Credit Agricole. 

Credit Agricole's call comes in the wake of a punishing week that saw the Euro fall back toward its year-long low beneath 1.15 after Italy's coalition government unveiled a 2019 budget plan that places the Mediterranean nation on a collision course with fiscal hawks in Brussels. 

Nessun azzardo, la nostra manovra economica è coraggiosa ma anche responsabile. Comunque, Europa o non Europa, io non cambio idea e seguo sempre lo stesso principio: #PRIMAGLIITALIANI! pic.twitter.com/lhlikVM5d1

— Matteo Salvini (@matteosalvinimi) September 29, 2018

"Market uncertainty may linger ahead of the publication of the finalised budget in mid-October, which could put the Italian populists on a collision course with the global rating agencies and the European Comission," says Valentin Marinov, head of FX strategy at Credit Agricole.

Italy's government is widely reported to be planning a 2019 fiscal programme that would see it run a budget deficit equal to 2.4% of GDP, assuming the administration's economic growth forecasts do prove too optimistic. Some say they might. 

"We do not yet know what the Government has assumed about GDP growth. But it seems likely to us that their forecasts are more optimistic than ours or the consensus. After all, the previous government’s forecasts were above ours. And from a presentation perspective, it would be difficult for the Government to mark down its forecasts while introducing its main policy proposals," says Jack Allen, a senior European economist at Capital Economics.  

This is a problem for Italy and Brussels because the former is in breach of the rules set out in the Maastricht Treaty, which forbid budget deficits in excess of 3% of GDP and national debt of more than 60% of GDP. Italy had a budget deficit equal to 2.3% of GDP in 2017 and national debt in excess of 130% of GDP. Italy has until October 15 to present its final budget plan to the EU Commission for approval.

"Indeed, a potential sovereign downgrade by either Moody's or the S&P later this month, or a growing risk that the EC would recommend the launch of the so called Excessive Deficit Procedure to help Italy rein in its fiscal excesses, could hurt BTPs and EUR," says Marinov.

The preventative arm of the Stability and Growth Pact gives the European Commission powers to impose medium-term budgetary objectives on member states, in other words budget targets, and when those are not met the Commission can then initiate and Excessive Deficit Procedure. 

Italy's medium term targets require an annual reduction in the deficit that is equal to at least 0.5% of GDP. While the exact budgetary black hole for 2018 is not yet know, plans for a 2.4% deficit in 2019 are sure to put the country in breach of the requirements. 

As a result the European Commission is within its rights to demand more austerity from the Italian administration and could eventually fine the government for non-compliance. 

But compliance from the government would be at odds with its election mandate and could lead to even greater anti-Euro sentiment in Italy, potentially endangering the nation's place as a member of the single currency bloc.

Marinov and the Credit Agricole team say the lack of stress in other European bond markets, particularly those of other financially challenged countries, during last week's Euro sell-off suggests that risks relating to Italy are already baked into financial market prices. They are wagering that the Italian budget drama will turn out to have been just a sideshow to a story that is more positive for investors over the longer term. 

"The above considerations would suggest that Italy -related negatives are in the price of EUR by now. They also make us expect the ECB to remain on its path of monetary policy normalisation - a process that should start with the end of the bank's balance sheet expansion in December and continue with first rate hikes in more than a decade in 2019. We continue to see EUR/USD as a policy convergence trade and keep our medium -term positive view," Marinov writes, in a note to clients Monday. 

Credit Agricole forecasts the Euro-to-Dollar rate will recover to 1.19 before year-end and that it will rise even further, to 1.27, in 2019. The EUR/USD rate was quoted 0.28% lower at 1.1569 Monday.

The idea behind the forecasts is that as the Eurozone economy recovers and inflation rises over coming quarters, the European Central Bank will feel encouraged enough to wind down the quantitative easing programme that has kept European bond yields so low in recent years, before eventually raising its interest rate. 

When this happens it could take some of the wind out of the U.S. Dollar's sails, at least as far as the Euro-to-Dollar rate goes, because changes in interest rates can exert powerful push and pull influences on international capital flows and also pose an effective lure for short-term speculators.

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