“GBP Remains a Consensus Short” But Euro-Related Political Risks Outweigh
The Pound is going down but the Euro is going even lower, says Bank of America Merrill Lynch’s Head of FX Strategy David Woo.
“Our baseline projections expect GBP/USD to hit a new low of 1.15 in Q1 after the UK activates Article 50,” says David Woo in a recent report.
Yet despite seeing Sterling revisiting the flash crash lows versus the Dollar because of Article 50, his view on the Euro to Pound pair is very different.
“We recommend selling EUR/GBP via a 6M 0.84/0.80 put spread, to capture both the referendum in Italy and the French elections, but also give time for GBP to recover in case it weakens further following activation of Article 50 in Q1. The structure costs 1.07% EUR,” says Woo.
A ‘put spread’ is a type of option’s strategy used when a trader expects a decline in the price of the underlying asset.
In this case, the expectations is for a decline in EUR/GBP to below 0.80 as that is the level below which the strategy will pay out.
Yet what could explain the seemingly monstrously wide divergence between Woo’s forecasts for GBP/USD and EUR/GBP?
In two words “political risk”.
Woo sees this as dominating Europe in the year ahead as many key elections have the potential of resulting in a rise of far-right populist parties and the possible dismantling of the European Union.
“We expect markets to become more concerned about political tail risks in the rest of Europe following Trump’s victory in the US elections.
“Political risks in Italy and France could question the sustainability of the Eurozone, thus weakening EUR/GBP,” says Woo.
Analysis of Political Risks
Woo sees the two main sources of risk for the Euro as emanating from elections in Italy (which have already passed) and France.
The Italian referendum led to a win for the “No” camp which rejected the idea of reforming the upper house, or Senate, and reducing its power.
Prime Minister Matteo Renzi, who had supported the “Yes” campaign resigned after the referendum.
According to Woo, this should have weakened the Euro due to increasing fears of a snap election opening the way for a win for the anti-Euro Five Star party.
However, this was not the case as the Euro strengthened following the referendum and the news of Renzi’s departure.
Nevertheless, even without a snap election, Woo points out how markets could still become jittery prior to an early 2018 election.
As for the French Presidential election, Woo sees an outside chance of Le Pen making a surprise win a la Trump:
“The 2017 French election is another concern. President of the far-right party and presidential candidate Marine Le Pen is ahead in the polls to win the first round.
“Winning the second round is much more difficult, as she will need more than 50% of the votes, but investors could start to expect the unexpected after being blindsided in the UK and the US,” writes the BOFAML strategist.
Risks Overstated?
If the main reason for seeing more downside for the Euro is political risk, then the question is, is that risk really as high as Woo suggests?
One thing which could explain why the Euro has shrugged off the resignation of Matteo Renzi so easily is that contrary to Woo’s analysis, his resignation does not now actually increase the chances of Italy leaving the EU.
As some analysts have suggested, the failure of the referendum to reform the upper house and remove its capacity to block or delay legislation will now actually make it more difficult for an anti-EU party to pass a bill for an Italexit.
Paradoxically it would have been easier had “Yes” won the referendum, and the powers of the upper house been curbed, for a future government to pass legislation which could lead to Italy leaving the EU.
The “No” win has also focused Italy’s leaders on making sure that Five Star is kept out of government.
As a consequence, they may be keener to amend recent reforms of the electoral system collectively known as the Italicum.
The Italicum basically increases the power of the largest party by giving it a disproportionately higher share of the seats in parliament.
It was designed to support majority rule and strong government, ending the previous system which encouraged coalitions.
In its present format, the Italicum is the biggest threat to Euro as it could lead to a government in which Five Star had a majority and could, therefore dictate policy.
However, there may be more will to amend it substantially and curb the power of the party with the majority due to growing fears of Five Star.
Indeed, the Italicum is currently being challenged in the Italian Constitutional Courts so may be deemed illegitimate in its present form as well.
Le Pen’s Uphill Struggle
The threat of Front Nacionale's Marine Le Pen coming to power could also be overdone.
Le Pen seems very likely to make it to the second round of France’s presidential elections on 7 May 2017, but she is unlikely to prevail in a two-candidate showdown.
The latest opinion polls show she would be ‘crushed’ by the conservative candidate Francois Fillon in the final round.
For Le Pen, Fillon would be the hardest candidate to beat as he is already quite right wing and many of his policies overlap with hers’, suggesting he might steal a share of her voters.
