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Pound-Euro can get Back Above 1.40 Long-Term as Euro Loses the Trust Factor

1) A Liga / Five Star government appears inevitable

2) Potential for ever-larger financial Italian deficits threatens Eurozone stability

3) Euro's chances of becoming the global reserve currency are now remote - Commerzbank

4) "The Euro has always been, in my mind, the St. Andreas Fault" - Sandler and O'Neill & Partners

Eurozone and the Euro

© Grecaud Paul, Adobe Stock

One question we have been consistently asked by readers since the UK's Brexit referendum of June 2016 is whether the Pound-to-Euro exchange rate will ever again achieve the +1.40s witnessed in 2015.

Based on the trajectory of Brexit and expectations for below-trend future economic growth, such rich levels are understandably not contained in any exchange rate forecast tables covering the next three years held at the major institutions.

One key assumption underpinning expectations for a low GBP/EUR is an expectation that Eurozone political instability is a fading background risk. Another pro-EUR assumption relates to steadily improving Eurozone finances; ever since the European Central Bank effectively put paid to the Eurozone sovereign debt crisis back in 2014 the question of fiscal instability in the Eurozone has also faded.

But, following three years of relative calm, volatility has returned to Eurozone financial markets thanks to political uncertainty in Italy and, to a lesser extent, Spain, leading analysts to question future Euro strength.

"The Italian government has been able to stabilise its debt-to-GDP ratio in recent years due to sizeable fiscal surpluses, but it is uncertain whether that austerity will continue," says Jay H. Bryson, Global Economist, with Wells Fargo.

Looking at the political outlook for Italy it seems inevitable that some combination of the anti-establishment, anti-Euro Five Star Movement and Liga parties will form the next democratically-elected administration. One of the key priorities of a Liga / Five Star government would be to implement campaign pledges to boost spending significantly in defiance of European Union budget rules.

This poses significant challenges for Italy as "renewed fiscal largesse could lead to a vicious circle of increasing fiscal deficits, higher borrowing costs, slowing economic growth, even larger deficits. The probability of such a vicious circle developing seems to be lower in Spain than in Italy," warns Bryson.

Italy's place in the Eurozone long-term is therefore questionable, and when a Liga / Five Star government eventually takes the reins investor sentiment and confidence in the Euro will ultimately be kept in check.

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Investor Doubts to Keep a Long-Term Cap on the Attractiveness of the Euro

As recently as 18th May Ulrich Leuchtmann, an economist with German lender Commerzbank, predicted that the Euro might push aside the Dollar as the dominant leading world currency.

However, since publishing these views fears of an Eurozone crisis have returned thanks to Italy, leading Leuchtmann to warn his assumptions on the ascendency of the Euro have had to be pared back considerably.

Italy is seen by the economist as a potential weight around the Euro long-term, but it's not just about Italy and more about the construct of the Eurozone itself which is likely to hamper the Euro long-term.

Leuchtmann wrote to clients on 18th May setting out his belief that actions by US President Donal Trump could spell the end of the Dollar’s reign as leading world currency.

Policy developments lead him to believe the status of the Dollar as leading world currency might be eroded; particularly that of sanctioning various countries with the obvious example being Iran. US sanctions on Iran has forced a number of customers to pay for Iranian oil in Euros, in turn questioning the dominance of the petro-Dollar.

Due to the fact that the Euro has increasingly been used in international payment transactions, and with no other currency able to compete with the Dollar and Euro in this respect, Leuchtmann came to the conclusion that the European single currency was currently the only possible candidate to replace the Dollar in its special position.

But, recent political developments in the Eurozone have effectively jettisoned this idea.

"My view had however been based on the assumption that the Eurozone crisis was over once and for all and that there was no risk of it resurging. But that is exactly what might happen now," says Leuchtmann.

The Commerzbank analyst observes the risk premiums for Italian government bonds have shot up over the past few days and this serves to illustrate that many market participants are clearly worried about a return to the times of crisis.

And, "a currency in crisis is not very suited as a world trade currency," says Leuchtmann.

Leuchtmann warns Eurozone crises might make Euro exchange rates more volatile and lead to inaccuracies in exchange rate hedges having more pronounced effect on the profits of the foreign trade sector.

"Exchange rate risks would rise," says Leuchtmann. "Doubts in the long-term existence of the single currency entail new problems: how would Euro denominated contracts be processed in case the Euro was to fall apart? Legal risks would rise."

The Commerzbank economist warns that as long as the Euro is not perceived as a stable currency structure long term, it will be unable to provide competition to the Dollar as leading world currency. "Over the recent past it seemed to possess this stability, but clearly increasing numbers of market participants question this view now."

The sentiment is shared by Wells Fargo's Bryson who says that while it is too early to make confident predictions about how the situation in Italy will ultimately evolve, instability and volatility are the only guaranteed certainty moving forward.

"Much will depend on political decisions that are made in coming months, not only in Italy but in other European countries as well. Readers should be prepared for more volatility in coming months as domestic and foreign actors in the Italian saga make their decisions," says Bryson.

Robert Albertson, chief strategist at Sandler and O'Neill & Partners, agrees with his industry colleagues, saying in his mind for investors, "the bottom line is Europe is the biggest risk if you want to worry," and the Euro itself is a key ingredient to this risk.

"The Euro has always been, in my mind, the St. Andreas Fault," says Albertson in an interview with CNBC. “The Euro, ironically, was developed in the hope that it would add further prosperity. Instead, growth across the Eurozone has been stagnant at best, and the likes of Spain and Greece have jumped from crisis to crisis."

With the above arguments in mind, were readers ask me again if the Pound-Euro exchange rate could ever get back to 1.40, the answer would have to be a "yes" - but it will take a long time.

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