Euro Outlook Clouded by Growing Political Risks Posed by Portugal

Political risk is once again on the agenda as another peripheral Eurozone nation offers markets the promise of a deterioration in risk sentiment.

Political risks have grown over the past 48 hours with eyes focussed on transition in Portugal. Only two weeks after Portugal’s government was sworn in, it has been ousted by a newly formed left-wing party alliance.

The euro fell sharply against the pound sterling which was boosted by a robust jobs report earlier in the day.

The euro to dollar exchange rate meanwhile managed to defend the 1.07 support line on thin volumes owing to a holiday in the United States.

"Political uncertainty is already having significant costs. Portugal 10y sovereign spreads have increased to over 215bp versus Bunds and more than 90bp versus 10y Spanish Bonos. The political uncertainty takes place against a background of still elevated private and public debt," says Antonio Garcia Pascual at Barclays.

Their majority of 122 superseded the centre-right minority’s 107 of the 230 seats, forcing Prime Minister Perdo Passos Coelho to step down.

This leaves the decision to Portugal’s president, Aníbal Cavaco Silva. He will decide whether Portugal will have new elections under a caretaker government or appoint a left-wing government.

If Silva appoints a left-wing government, political analysts predict this government will be “unstable and short-lived” because the alliance is made up of at fractions who have wildly different policies.

Despite pledges by current party leader, Antonio Costa, policy making in such an alliance will be a difficult task and comes with a high risk of fiscal slippage.

"While political uncertainty in Portugal does not bode well for the euro, a Greece-like scenario is not in the cards. Portugal's fiscal backdrop is much more manageable than Greece's," said Elias Haddad, senior currency strategist at Commonwealth Bank. "Rather, expectations of more ECB easing will continue to keep the euro under downside pressure."

Brexit Clouds Outlook for Sterling

Another big theme for the pound / euro exchange rate to navigate in the future is that of Britain's continued presence in the European Union. 

UK Prime Minister David Cameron sent a letter to Donald Tusk, President of the EU Council, listing key areas where the UK demands EU reform for continued membership in the European Union.

These four key areas are in governance, business regulations, British sovereignty and immigration. Pursuant to this, a referendum of the British public will occur by 2017.

As with other negotiations between governments, it is believed that these key areas were discussed with the EU governments before the letter was sent out. But while these renegotiations may be accepted by the EU, the outcome of the referendum is uncertain.

As we have noted here it is too soon to attribute major moves in the pound exchange rate complex to Brexit, but the issue will certainly weigh on the currency in 2016.