Euro Shivers as Analyst Warns Italy can be "the Straw that Breaks the Camel's Back"

- Markets starting to take notice of potential Italian policy under new leadership

- Damage to Euro still limited at this stage

- But IG warn Italy could still be the proverbial straw that breaks the camel’s back

© Stadtratte, Adobe Stock

For foreign exchange markets, Eurozone politics are back to the fore now that a coalition government appears close to formally taking power in Italy.

Italy's League and Five Star Movement - two parties that occupy different ends of the political spectrum but are united by their radical agendas - appear to be inching towards sealing a deal to govern Italy.

Markets had initially been sanguine on news that these unlikely bedfellows are coming together, adopting the belief that they would ultimately fold into a compromise agreement which in turn allows the status-quo to more-or-less continue.

But leaked policy agendas that might be implemented under the marriage have given markets something of a shudder over the course of the past 48 hours.

The Financial Times ran a story discussing an early draft of Italy’s populist parties’ platform for the upcoming government, which included a mechanism for leaving the EU and a request that the ECB write off EUR 250 billion of Italian sovereign debt.

"The Euro may continue to broadly underperform here – even against Sterling," says John J Hardy, Head of FX Strategy at Saxo Bank. "As some have pointed out – the irony here is that without Italy, the Euro should be much stronger."

One of the draft ideas is to demand the cancellation of €250bn (£220bn; $295bn) of Italian bonds bought by Italy's central bank under the European Central Bank's asset purchase programme which is designed to stimulate the Eurozone economy.

Wanting the debt cancelled is understandable as Italy has the second-highest public debt in the Eurozone after Greece, yet the two parties are planning to increase budget expenditure by tens of billions of euros, with plans for a minimum universal income and a flat tax of 15% for low and middle earners.

The two party leaders have meanwhile also launched an attack on EU officials, accusing them of interfering in the talks process while reminding markets of their anti-EU roots by balking at a host of European Union and Eurozone rules. They have also accused markets of blackmail and the Financial Times of spreading 'fake news'.

Despite a distinct Trumpian tinge to the new Italian order, the impact on the Euro is yet to really be felt at this point with markets still apparently willing to wait for more concrete details.  

Analyst Shaun Osborne at Scotiabank says Italian politics are now seen to be weighing on Euro sentiment, as German Bund/BTP spreads have widened significantly in the past few days, but he is not yet convinced the Euro will suffer too much damage.

"The yield gap at 141bps is only just returning to levels seen two months ago, hardly a crisis at this point," says Osborne. "The EUR itself has been less sensitive to developments in peripheral sovereign yields/spreads more recently, which makes the EUR’s latest swoon perhaps look a little more like more positioning cleansing than a more significant shift in bearish sentiment."

Ultimately, for the Euro, the question to be asked is how do Italian politics impact the future of the Eurozone; we will need to see some concrete moves in an anti-Eurozone direction before the Euro really starts to pay attention.

The problem is that when 'non-establishment' politicians are involved, there is a degree of uncertainty and potential for rude surprises.  

"Italy should give investors pause for breath, although at present it is not quite having any real impact, since the likely coalition government seems set on upending the existing eurozone order. How far they plan to go remains a question that is yet to be solved, but it brings back uncomfortable memories of the eurozone crises of years past," says Chris Beauchamp, Chief Market Analyst at IG.

Beauchamp says that back in the last Eurozone crisis, "it was always said that the single currency union could survive the departure of Greece or Portugal, but that Italy would be the proverbial straw that broke the camel’s back. Italian assets are diverging from their eurozone brethren today, but if things get worse and these plans move closer to reality then we can expect the contagion to spread."

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