EUR/USD: Sell the Euro Rally before Italy Flares Up Again say Credit Suisse

-EUR/USD rate continues recovery off year-long lows.

-Good to sell rally over the summer say Credit Suisse.

-Good to buy now, targeting move to 1.20, say Nomura.

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The Euro-to-Dollar rate continued to rise Thursday as fears of an Italian push to leave the single currency subside and the European Central Bank gears up to wind down its quantitative easing programme, but strategists at Credit Suisse say the latest rally is an opportunity to bet on fresh weakness later this summer.

Italy's love-hate relationship with the EU and single currency are at the centre of the Swiss lender's latest strategy recommendation because, not only was it the protagonist in the June sell-off that pushed EUR/USD close to a one year low, it will also prompt fresh losses in the months ahead. And an end to the ECB's bond buying programme may only make things worse for the currency. 

"We suspect rallies into a 1.18-1.20 will likely meet sellers in EURUSD, with the latter level likely to be very stiff resistance even if all goes well given it is around the 200-day moving average, not to mention a key psychological evel. EURJPY 130 and EURCHF 1.1650 (just below the 200-day moving average) also seem likely to act as resistance / re-selling levels," says Alvise Marino, an FX strategist at Credit Suisse.  

Above: Euro-to-Dollar rate shown at hourly intervals.

Immediate concerns over Italy's place in the Eurozone have subsided since the nation's two largest political parties, M5S and League, agreed the makeup of a coalition government. Previously, President Mattarella's veto of the coalition's decision to appoint an arch-Eurosceptic to the post of finance minister had sparked fears of a so called constitutional crisis and an increase in anti-Euro sentiment in Italy. 

Unease dissipated further on Tuesday when Prime Minister Giuseppe Conte unveiled the new government's agenda in the Senate, omitting previous pledges to roll back key 2011 pension reforms and saying nothing about VAT sales tax rises currently planned for 2019. However, the government has pledged to push forward with a "flat tax" programme and signalled that Italy's days of austerity are now over. 

"We were struck by new PM Conte's speech to the Senate yesterday and his assertion that Italy has "negotiating power" vis-avis Europe given his view that "Italy's interests coincide with Europe's general interests". Although not explicit, we see in this comment a hint that Conte and the populists might consider Italy a case of "too big to fail" in the European context, and as such capable of exerting its influence to change Europe's political and even budgetary trajectory," Marino writes.

The Credit Suisse team say Conte's speech places the government on a potential collision course with European Union budget hawks. They might be right as well because post-crisis regulations, known as the "Two Pack" regulations, require member states' to submit draft budgets to the European Commission for approval each October.

The rules give the Commission the ower to approve or veto member states' budgets and provide a mechanism for enforcement of the so called Stability and Growth Pact an Maastricht Treaty rules that seek to limit budget deficits to no more than 3% of GDP and national debt to no more than 60% of GDP.

Above: Euro-to-Dollar rate shown at daily intervals.

Fears are these rules may see Italy and Brussels come to blows later this year. Anti-Euro sentiment is already running high in Italy since the Eurozone debt crisis, and the resulting budget enforcement mechanisms, wrought far reaching austerity measures on the Italian public. Another conflict with Brussels, or forced wave of austerity, just might prompt the M5S and League coalition to renew earlier efforts to get Italy out of the Eurozone. 

Looking beyond the next 2 months, we still see trouble potentially on the horizon within 4 months as Italy's 2019 budget debate heats up. As such, all else being equal, we are still inclined to fade EUR rallies in the near term, assuming that another material leg lower due to Italy could start around August / September," Marino says. 

The Euro-to-Dollar rate was quoted 0.31% lower at 1.1818 during the morning session Thursday. It is now down by 1.46% for the 2018 year but Marino and the Credit Suisse team say it can extend that loss later in 2018. They also flag the EUR/JPY and EUR/CHF rates as worth selling too. But strategists at Japanese lender Nomura have adopted a different tactic, recommending on Wednesday that clients bet on a short-term increase in the Euro-to-Dollar rate. 

"While the timing of a rate hike is still uncertain at this stage, the correlation of EUR to Italian spreads is starting to fall once again, although levels are attractive to expect retracement of the recent risk-off moves. Italy is still a concern, but it is less of a broader EUR contagion story. We therefore enter long EUR/USD to take advantage of its recent outsized fall,” says Bilal Hafeez, global head of FX strategy at Nomura, in a recent note.

The Nomura team advised clients to buy the Euro-to-Dollar rate around the 1.1760 level and target a move up to 1.20, with a stop-loss at 1.1640. The exchange rate has since risen from their entry price and is being supported by a renewed focus in the market on a likely end to the European Central Bank quantitative easing programme at some time over the summer, after ECB chief economist Peter Praet hinted earlier this week that it is in the cards

Above: Euro-to-Dollar rate at weekly intervals.

An end to the ECB bond buying programme would provide financial markets a green light to begin contemplating an eventual interest rate rise some time next year, which should be positive for the Euro and has already helped it to recover some earlier losses. However, recent and ongoing events in Italy could mean an end to the bond buying programmes is a double edged sword for the single currency.

This is because it is the European Central Bank's presence in the Italian bond market that has kept Italian bond yields anchored at sustainable levels throughout the recent volatility. But when the ECB stops bidding for Italian government debt, the yields may rise disproportionately to those of German and other Eurozone government bonds if the cessation coincides with a fresh concerns over Italy. 

And the Euro has a negative correlation with the gap between German and Italian bond yields which, presumably, would mean the single currency will come under renewed pressure later this year if the ECB curtailing its QE programme leads to a widening of the so called "yield spread". 


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