EUR: Dodging bullets - Rabobank

Jane Foley, Research Analyst at Rabobank, notes that the sell-off in the EUR after the ‘no’ vote in the weekend’s Italian referendum proved to be extremely short-lived. 

Key Quotes

“In the end it wasn’t the result of Italy’s vote that surprised but the extent of Renzi’s failure.  Although this may mean that Renzi will not be asked by the President to form a caretaker government, the market has adopted a pragmatic view on the next phase of Italian politics.  A caretaker government led by a respected politician is considered the more likely outcome for Italy.  While this may not be the best case scenario for any country, this is unlikely to offer a direct threat to Italy’s position in the EMU.  The risk of bank contagion still has to be managed and the 2018 elections still suggest the possibility of anti-EMU populist parties claiming more power in Italy.  That said, the rejection of Renzi’s constitutional reforms means that the power base remains divided and there is less chance of a ‘strong man’ politician taking the helm.  For now it seems that both Italy and EMU will continue to muddle through.  Since the level of shorts has been creeping higher in recent months, this view has provided sufficient relief to push the EUR higher.”  

“Potentially a bigger risk for EMU coherence is next year’s French Presidential election.  Polls have been indicating that the populist Far Right leader Le Pen would lose in the second round of the election to the winner of the Republican Party primary.  Surprising this has been won by the reformist Fillon whose Thatcherite policies include significant labour market reforms.  Although this outcome would be popular with the financial markets, it would mark a significant change for France.  Although an opinion poll published by Ifop-Fiducial suggests that Fillon would win 65% of the vote in the second round, many market participants are likely to retain a healthy scepticism of poll given their misleading implications for recent elections both in the UK and in the US.”  

“As the April/May French elections approach, it is likely that the EUR will adopt a fairly binary relationship with French political news.  Indications that Fillon will win are likely to be supportive while a boost to Le Pen’s support are likely to see the EUR softening in view of her calls for a referendum on France’s membership of EMU.  The EUR could see some benefit from the Dutch elections on March 15.  Although polls are indicating that the current governing coalition is unlikely to return to power, a Eurosceptic coalition seems unlikely and thus the outlook for EMU coherence could be given a boost.  While the German elections later in the year could bring increased support to the Far Right, a more liberal governance is currently expected to prevail.  This view, however, may be at risk if tensions over the migrant crisis surge again.”

“While it is our central view that Euro-scepticism will be kept in check next year, the clear rise of nationalism across Europe and uncertainly connected with next year’s elections suggests that volatility in the EUR is set to remain heightened.  The experience of the GBP this year is testament to the potential impact on a currency of political uncertainty.  That said, the EUR is likely to exhibit different behaviours to the pound as a consequences of positioning and the Eurozone’s healthy current account surplus.” 

“Since the market is already short of EURs, it reaction to negative news should be lessened.  The fact that the region has a very significant current account surplus (EUR25.3 bln in September) should also provide a cushion.  Since it is our central scenario that EMU will continue to muddle through in the coming years and since it is our belief that the market’s US reflation expectations are overdone, we are forecasting EUR/USD at 1.10 on a 12 mth view.”