Euro Rebounds vs. Pound Sterling and the Dollar as Moody's Delivers 'Gentle' Downgrade to Italian Debt

Image © Stadtratte, Adobe Stock

The Euro exchange rate complex starts the week on a strong footing after a major ratings agency delivered a 'gentle' downgrade to Italy's sovereign debt rating over the weekend which triggered a fall in the cost of servicing that country's debt.

The market has been demanding a greater premium for holding Italian debt over recent weeks amidst rising concerns the new governing coalition's budget plans to boost spending and cut taxes would make the country's debt dynamics unsustainable.

The concerns have in turn weighed on the Euro exchange rate complex of late.

Moody's downgraded Italian debt one notch on Friday to Baa3, but it crucially set the outlook assessment on 'stable', which eased the fears of Italy being downgraded to junk.

"A material weakening in Italy's fiscal strength, with the government targeting higher budget deficits for the coming years than Moody's previously assumed," was cited by Moody's for the downgrade.

"The stable outlook reflects the broadly balanced risk at the Baa3 rating level. In Moody's view, Italy still exhibits important credit strengths that balance the weakening fiscal prospects. These strengths include a very large and diversified economy, a solid external position with substantial current account surpluses and a near balanced international investment position. Italian households have high wealth levels, an important buffer against future shocks and also a potentially substantial source of funding for the government," add Moody's.

"EUR gained on relief that the credit rating company Moody’s was as gentle as possible with Italy," says Marshall Gittler with ACLS Global.

"This was the least damaging move Moody’s could do; it could’ve downgraded Italy to below investment grade, which would have forced many bond funds sell their paper and sent the price down sharply. The relief rally started in the FX market this morning as EUR was higher. I would expect EUR to continue to gain today as other Italian assets, such as stocks and bonds, rally and improve sentiment towards the country," adds Gittler.

At the time of writing the Pound-to-Euro exchange rate is quoted at 1.1336, having been as high as 1.1463 earlier in the month, the Euro-to-Dollar exchange rate is at 1.1537, having been as low as 1.1460 last week.

The immediate outlook for the Euro will remain tied to the Italian budget story with Rome and Brussels likely to squabble over the country's budget for some time and we warned last week that the issue could weigh on the Euro with some analysts even suggesting the matter presents the seeds of another Eurozone crisis.

Ulrich Leuchtmann at Germany's Commerzbank notes "the combination of the tax-cutting right-wing populists and happy-to-spend left-wing populists in Rome has provided Italian bonds with a momentum that very much reminds of 2011." 2011 saw the Eurozone debt crisis blow up as peripheral nations struggled to repay the debts racked up in the good years that preceded the great financial crisis of 2008.

"It could be a matter of time before the Euro falls through the bottom of its range after the EU signalled a thumbs down to Rome’s budget for the coming year," says Joe Manimbo, a foreign exchange strategist with Western Union.

The E.U. commission last week responded to Italy's budget plans, giving the government until Monday to explain its “obvious significant deviation” from the E.U.’s rules. The budget set by Italy's coalition government currently breaches the E.U.'s Stability and Growth Pact which requires Eurozone states to respect limits for budget deficits and public debt of 3% and 60% of GDP, respectively.

The letter was a clear indication that the E.U. could be preparing the ground for an unprecedented rejection of a member state’s fiscal plan.

Italian newspaper, La Repubblica, says that the Italian government is reported to tell the European Union that is going forward with the budget plan. Italy have said they will respond to the E.U. by 10:55 B.S.T.

Danske Bank's von Mehren says he expects to see some relief in Italian markets today after the E.U. Commissioner Pierre Moscovici said that the E.U. wouldn't interfere in the new government economic policies'.

Short-term it looks like some relief is on offer, longer-term this issue could simmer and we remain wary of any escalations.