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Euro's 2018 Rally Threatened by Italian Election, Debt Fears and an End to Quantitative Easing

Above: Mario Draghi, President of the ECB, faces a tricky year ahead as politics could meddle with his plans for Eurozone monetary policy, (C) European Central Bank.


Predictions for a stronger Euro in 2018 continue to stack up, but risks to the consensus assumption are growing, with Italy front and centre on stage. 

Italy poses a threat to those hoping to see a continued ascent of the Euro during 2018 as the country's general election, set for March 04, could see the elevation of Eurosceptic politicians in the European Union's fourth largest economy.

The foreign exchange analyst community continues to galvanise around the idea that the trend of Euro appreciation which begun in 2017 will continue through 2018 with many institutional names now seeing the EUR/USD exchange rate going as high as 1.30.

Analysts do however acknowledge the threat posed by a disruptive outcome in Italy where polls paint a picture of a country that is divided along political lines.

“Recent developments in Italian politics have further increased the probability that the election outcome will be a very fragmented parliament and made the formation of a governing coalition after the election more difficult,” says Dr. Loredana Federico, chief Italian economist at UniCredit Bank in Milan.

The best that Italians can hope for, according to the analyst community, is a hung parliament where parties of all persuasions ultimately cobble together a coalition that is able to rule at the most basic level, but which will be unable to force further economic reforms through the upper and lower houses of the legislature.

“Eurosceptic parties may well be kept from power come March; but even so, no executive will be in a position to offer a swift remedy to the structural issues blighting the economy,” says Neil Mellor, a currency strategist at BNY Mellon.

The largest political force in Italy, the Five Star Movement (M5S), has called for a referendum on the country’s use of the Euro if the party is unsuccessful in negotiating waivers to budget deficit rules that have seen Italian voters clobbered with years of crippling austerity.

“We remain convinced that should the M5S gain a vote share similar to that currently suggested by the polls, it is very unlikely that it will decide to form a government with other parties, as 1. it lacks natural coalition partners, and 2. any potential alliance with traditional forces, with broadly similar relevance in terms of number of seats gained, is very likely to cause strong discontent among their activists,” says UniCredit's Federico.

M5S is an anti-establishment party, with around 29% support in the polls, and has always said it will not be willing to contemplate a coalition with any of Italy’s more traditional political forces.

This aversion to coalition politics, and recent reforms to Italian electoral law that mean parties or coalitions need a minimum of 40% of the vote in order to govern, has led markets to write it off as a likely victor March’s election.

“A very fragmented parliament remains the most likely outcome, making it difficult for any party or coalition to gain an absolute majority of seats. This could lead to a hung parliament or to a government of national unity/a broad coalition,” Federico adds.

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Italy's Crippling Debt and the ECB

Analysts have suggested that ahead of the vote, markets could begin to command a risk premium for holding the Euro, which means the common currency is likely to weaken as the election approaches.

The Italian vote will take place amid a renaissance for the Eurozone economy, as well as the Italian economy, with the currency bloc just having seen out its best year in more than a decade in terms of economic growth.

Assuming economists, currency strategists and polls are right and there is no shock victory of the M5S at the March ballot, Italian politics could soon fall by the wayside as a risk for the Euro.

But Italy could still hamper the Euro's trend higher owing to its gargantuan public debt piles which must continue to be funded by further borrowing. Much of the financing has been done by the European Central Bank which has funded Eurozone debt via its quantitative easing programme over recent years.

But the ECB communicated in 2017 that is now withdrawing this support, which has in turn seen the Euro rise. But these plans could be questioned if the ECB fears its withdrawal from the markets could destablise countries such as Italy.

"Certainly, Italy has been on the mend - thirteen consecutive quarters of growth has made serious inroads into the country’s bad loans," notes Mellor. "But falling from record highs, the latter remain high nonetheless, which makes for an inauspicious starting-point for any policy normalisation – particularly in an economy with over a tenth of its workforce unemployed (one third for youth) and with a debt-to-GDP ratio of 130%."

The ECB said in October that it will cut its monthly bond purchases in half, down to just €30 billion, from January. Expectations of a cut back helped drive a double digit rise in the Euro during 2017.

It has been buying €60 billion of government and corporate bonds per month ever since early 2015, with the ultimate aim of spurring inflation, which had been weighed down by years of post-crisis stagnation and a collapse in commodity prices.

The bank says it will continue buying bonds every month until September 2018 or beyond but, already, bullish predictions for the common currency in 2018 are stacking up as strategists bet on a full curtailment of QE and another rally from the Euro.

“Moreover, given that the ECB has effectively funded the country’s budget in recent years (buying EUR 319 Bn of Italian debt), the Italian government faces the prospect of rolling over bonds in a market whose limited contingent might understandably demand a rather sizeable premium,” adds Mellor.

But the rub for the Euro's appreciation story is that the ECB has become such a large part of the Eurozone bond market it might be difficult for it to exit the stage without causing an upset at any point in the near future.

“Suffice to say, this will be a challenge. Indeed, recall that ECB chief economist Peter Praet told Der Spiegel in June that Italy would be on its own if APP tapering led to a rise in its debt spreads,” says Mellor. “But then, in view of the risks that this would entail, is it reasonable to assume that the ECB would simply stand by?”

The central bank has gone far further with its own extraordinary monetary policy than any of the Western world’s other central banks, injecting new money equivalent to 40% of Eurozone GDP into the financial system over the last two years.

This is nearly twice what the Federal Reserve did during its own quantitative easing years and the US central bank, despite having two full years of so called “normalisation” under its belt, is yet to actually shrink its balance sheet.

The scale of the ECB’s balance sheet combined with the length of time that has elapsed without the Federal Reserve being able to lighten its own load highlights and underlines the gargantuan task ahead of Mario Draghi and the governing council.

Meanwhile, Italy’s budget deficit has commanded much of the austerity wrought on the country in recent years, with this being the source of much of the country’s political discontent.

However, a sharp and sudden rise in Italian bond yields, brought about by the ECB taking too big a step backwards, could force Italian borrowing costs higher and exacerbate its budget deficit even further.

Such a development is unlikely to remain contained to Italy for very long and so the very prospect of it occurring might be enough to see the ECB move toward the exit slower than the market expects.

This would heap downward pressure onto the Euro in the latter half of the year.

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