The Salvini Factor Tipped to Cap the Euro's Recovery Potential

Above: Matteo Salvini. File photo © European Union - European Parliament

- Euro hit by political uncertainty in Italy

- Salvini’s Liga leading polls

- Safe-haven role a probable offsetting factor

The Euro is likely to struggle to gain meaningful upside traction in the near-term as Italian political risks appear to be flaring up once more.

Any rallies in the Euro are likely to be capped by political risk as Italy’s deputy prime minister Matteo Salvini set the cat amongst the pigeons this week after saying Italy should break with Brussels budget rules which were "starving the continent", especially in relation to tackling high unemployment, and must be changed.

"If there are European rules that are starving a continent, these rules must be changed," Salvini told reporters when asked about his comments on Tuesday, which sent Italy’s 10-year bond yield to a two-month high and pushed the spread between Italian and German yields to their widest level in three months.

Asked if he was worried that his remarks were widening the spread, he said: “absolutely not, because Italians’ right to a job, life and health comes first.”

The Euro is not so much worried by what happens on a national scale, rather it is more likely to be responsive to national events that threaten the broader structure and functioning of the broader Eurozone, and European Union.

The breaking of fiscal rules is problematic as it creates a systematic risk for investors to consider.

On Wednesday, investor fears spread to the Italian share market and rippled through stocks across Europe.

Adding to the political risk factor is the proximity of the EU elections on May 23-26 for which Salvini’s league party is leading polls with 32% and the fact his comments have sown discord with his coalition partner, 5-star’s Luigi Di Maio, who attacked his partner’s comments as “irresponsible”.

A break up of the coalition could lead to fresh elections and the possibility of a Salvini outright victory, according to ING Bank analysts, which would put a eurosceptic nationalist leader in charge of the Eurozone’s 3rd largest economy.

Italian national bond prices fell after Salvini’s comments and the Euro came under pressure. Its gains are now likely to be capped according to currency analysts at ING Bank.

“If the weak recovery in the eurozone, renewed global trade tensions and flattening yield curves were not already bad enough for the euro, it now has to contend with renewed populism out of Italy,” says Chris Turner, global head of strategy at ING Bank. “Given this background, it’s unlikely that today’s 0.4% QoQ 1Q19 German GDP release will be enough to trigger a sustainable bounce in the EUR/USD."

ING say 1.1250/60 may well prove the top of the range for EUR/USD and they also expect EUR/JPY to drop towards a 1m target of 120.

While the upside is certainly capped, we would not expected Italy to result in an all-out rout of the single-currency.

We have noted recently the Euro has been gaining from capital inflows amidst the flaring up of U.S.-China trade tensions.

The Euro appears to have caught a bid on repatriation flows from investors who borrowed in Euro’s at the rock-bottom interest rates, and then invested that money in riskier, higher-yielding, international assets.

"The Euro ... is higher and may finally be benefiting from risk aversion - it's an increasingly popular funding currency," says Kit Juckes, a foreign exchange strategist with Société Générale.

Not only are interest rates in the Eurozone low but they are set to stay low, according to economists at Danske Bank, who now foresee the European Central Bank (ECB), the body that sets Euro Area base interest rates, keeping them unchanged until 2022.

“We have pushed back our call for the next ECB rate hike (policy rate currently at -0.40%) from H2 20 to early 2022. As such, we no longer expect the fixed income market to price rate hikes during H1 20. As a result, we expect German Bund yields to trade at close to zero for the next 12 months,” says Aila Mihr, senior analysts at Danske Bank.

This is likely to keep market rates low too since the ECB is the bank of banks.

It also means the dynamic which exists by which the Euro attracts safe-haven flows will also continue over that period which could provide the currency with some downside protection in the event of China-U.S. trade relations worsening.

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