Euro Holds Ground after Italian Bond Market Shrugs Off Brussels' Action on Government Spending Plan

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- EUR advances even after Brussels takes action on budget deficit.

- As Italy-Germany bond spread unmoved, but can the peace last?

- Council to dictate EU's next steps as Italy rejects latest demands.

The Euro continued to rebound against the Dollar Wednesday even after Brussels said it will launch an "Excessive Deficit Procedure" in an attempt to reign in the Italian government's budgetary ambitions. 

Price action comes as the Dollar softens and the spread between Italian and German bond yields remains stable despite the latest developments, although it remains to be seen if the debt market peace will hold for much longer.

A debt-based Excessive Deficit Procedure under the enforcement arm of the Stability and Growth Pact is now warranted according to the European Commission, as demands that Rome reconfigures its 2019 spending plans to comply with EU rules have been rejected. 

Deficit procedures are governed by article 126 of the Treaty on the Functioning of the European Union, which states the Commission must prepare a report to inform the European Council ahead of a discussion and subsequent vote on which actions to take. The report was published Wednesday.

"Macroeconomic conditions, despite recently intensified downside risks, cannot be argued to explain Italy's large gaps to compliance with the debt reduction benchmark, given nominal GDP growth above 2% since 2016," the Commission says. "Government plans imply a marked backtracking on past growth-enhancing structural reforms, in particular the past pension reforms."

The Commission's report takes particular issue with Italy having failed to comply with its July 13 demand for Italy to revise its budget so that it complies with EU rules and to abandon plans to reverse pension reforms. 

This places the ball jointly in the court of the Italian government and the EU's de facto upper chamber, the European Council, which is headed by a commission official but comprised of member nation's elected heads of state. 

Italy's Deputy Prime Minister Matteo Salvini told reporters in the Chamber of Deputies that the deficit target of 2.4% is "not negotiable" Wednesday but indicated the government might negotiate over other demands. 

"Has the letter from Brussels arrived? I'm waiting for one from Father Christmas too," Italy's ANSA reported Salvini as saying. "We will politely talk as we have always done. We will have dialogue. I'm going to keep going. If someone thinks they can convince me that the Fornero (pension reform) is right, they can try. I'm not convinced".

The problem for Brussels is that both sides of Italy's coalition government pledged, among other things, to ease off on austerity and reverse past pension reforms in their election manifestos. Coalition parties have since won office and grown their combined share of Italian support in the polls so that it now comfortably exceeds 50% of all voters. 

"What the FX market is looking for today is confirmation on how quickly (or slowly) the tensions will escalate. If Brussels rejects the draft budget and imposes fines, one would expect the Italian government to refuse to pay, and that forms the basis for the most negative EURUSD scenario," says Stephen Gallo, European head of FX strategy at BMO Capital Markets.

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

The Euro-to-Dollar rate was quoted 0.40% higher at 1.1416 Wednesday but is down 4.8% for 2018 while the Euro-to-Pound rate was 0.27% higher at 0.8917.

One possible reason the Euro's sanguine response is the latest developments are yet to unsettle the Italian bond market.

The spread (difference) between yields on Italian and German 10-year bonds, which has been a significant driver of recent price action, declined from an already-elevated level Wednesday. 

Above: Italy-Germany 10-year yield spread retreats back toward the3% handle.

"European politics cloud clean cash trades but we still think EUR longs look attractive around 1.14 and GBP leans higher," says Mark McCormick, North American head of FX strategy at TD Securities.

Fears are that any Commission or Council action that seeks to block implementation of government election pledges would simply turn the tide of Italian public opinion further against the Euro and European Union.

Such developments could see markets question Italy's place in the Union and single currency bloc, stoking renewed fears of a breakup, which could lead to a destabilising run on the Italian bond market.

Italy's budget proposal is for a fiscal programme that would see the government deficit rise from a projected 1.8% in 2018 to 2.4% in 2019. It then falls only to 2.1% of GDP in 2020.

This is a problem because Italy's targets under the preventative arm of the Stability and Growth Pact, which were set before the last election, require at least a 0.5% reduction in the deficit each year.

The Commission had reduced that target to 0.3% for 2019 to enable some investment in infrastructure and spending to accomodate migrants rescued from the Meditteranean sea.  

Italy is subject to the preventative and enforcement arms of the Stability and Growth Pact because its deficit and debt to GDP ratios breach criteria set out in the Maastricht Treaty.

Those criteria forbid deficits in excess of 3% of GDP and national debt of more than 60% of GDP. Italy had a budget deficit equal to 2.4% of GDP in 2017 and national debt in excess of 130% of GDP.

"The budget stand-off also lays the foundation for Rome to challenge Brussels on other issues in the run-up to next year’s EU parliamentary elections, which is the prize many Italian politicians have their sights set on," says BMO's Gallo.

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