Euro to Remain Constrained by Concerns Over Italy, Volatility to Pick Up says Barclays

© Pound Sterling Live

- EUR upside capped by fears over Italy's finances says Barclays.

- Volatility to pick up alongside tempo of budget row with Brussels.

- Tone, severity of row to dictate EUR position in 1.13 to 1.18 range.

The Euro will not be able to post meaningful gains over the Dollar in the months ahead, according to analysts at Barclays, who're warning that currency market volatility will increase as the budget row between Italy and the EU heats up.

Brussels' budget hawks rejected Italy's proposed 2019 spending plans, which were submitted to the European Commission for approval on Monday, setting the stage for a possible clash between the Mediterranean nation's "populist" government and the European Union's officials. 

"We think that at current levels a lot of the negativity is already priced with the near-term trajectory crucially depending on two things. The first is the outcome of the budget discussions between the EC and the Italian government. And secondly, rating agency reviews," says Nikolaos Sgouropoulos, a vice president of currency strategy at Barclays.

Italy's newly-minted government had proposed to run a budget deficit equal to 2.4% of GDP in 2019, up from an estimated 1.8% in 2018, while projections for subsequent years suggest it will be 2021 before the deficit gets back down to 1.8% of economic output.

Those deficit numbers assume Italy's GDP forecasts, which the EU and many analysts have described as optimistic, are on the money. This is a problem because Italy is in breach of 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. 

"It is the first Italian maneuver that does not appeal to the EU. No wonder: it is the first Italian maneuver that is written in Rome and not in Brussels!," says Luigi Di Maio, leader of the 5 Star Movement and Italy's deputy Prime Minister, in a Facebook post translated from Italian.

Above: Euro-to-Dollar rate shown at daily intervals.

Italy's medium term targets under the preventative arm of the Stability and Growth Pact require an annual reduction in the deficit of at least 0.5% of GDP. But the current budget proposal adds significantly to the deficit for at least the next two years, so Brussels-based officials have demanded the government go back to the drawing board. 

"The opinion adopted today by the Commission should come as no surprise to anyone, as the Italian Government's draft budget represents a clear and intentional deviation from the commitments made by Italy last July. However, our door is not closing: we wish to continue our constructive dialogue with the Italian authorities," says Pierre Moscovici, commissioner of economic and financial affairs at the European Commission. 

Italy's coalition government was elected in March 2018 on pledges to role back some forms of earlier austerity, implement new welfare programmes and to cut taxes. But rules contained in the EU's Maastricht Treaty, which all member states have signed, give the commission far reaching powers over the government spending of individual nations.

Now Brussels has demanded an alternative budget, it can set the ball rolling on a sanctions procedure if Italy does not comply. However, given the electoral climate, this would risk stoking anti-Euro sentiment in Italy and potentially endangering the nation's place as a member of the single currency bloc.

"As a base case we expect the tensions between the EC and Italy to mount in coming weeks introducing a lot of headline volatility and choppy price action for the EUR/USD. Under the base case however, we expect the pair to oscillate around our year-end forecast of 1.15," says Sgouropoulos.

Above: Euro-to-Dollar rate shown at weekly intervals.

Sgouropoulos also says the market would welcome both sides making concessions that resolve their differences over the budget, and that this would push the Euro-to-Dollar rate back toward the top end of its recent 1.13 to 1.18 range. However, he also says the Barclays team believe this is unlikely. 

Italy had a budget deficit equal to 2.3% of GDP in 2017 and national debt in excess of 130% of GDP. Ratings agency Moody's downgraded the country's debt to Baa3, one notch above "junk" status, this week in response to the budget plan. It left the outlook for the rating at stable but analysts like Sgouropoulos are now eyeing Friday's decision from S&P.

"Emphasis turns to the S&P rating decision on Friday. And while an index event seems unlikely in the near term, we think that concerns about Italian fiscal slippage coupled with expectations of higher U.S. rates should restrict the single currency's ability to post meaningful gains," Sgouropoulos warns. 

Italy now has three weeks from Tuesday 23 October to comply with the Commission's demand for a revised budget or face a sanctions procedure. But few if any expect the ongoing budget drama, or Italy's collision with the seemingly-immovable force that is Brussels, in just three weeks time. 

"The Italian Government’s reply to the European Commission suggests that there is unlikely to be a quick resolution to the current fiscal impasse. We expect yields to rise in the coming years," says Stephen Brown, a European economist at Capital Economics, "We are comfortable with our view that this will be a slow-burn issue for Italy rather than a full-blown crisis."

The Euro-to-Dollar rate was quoted 0.16% higher at 1.1483 Tuesday but is down 4.2% for 2018.

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