GBP could be the winner as external political risks heat up

There has been a double whammy of political risk hitting the markets at once this week: firstly the on-going saga of the US Budget. If a deal is not reached by midnight tonight then non-essential government services could be shut down tomorrow morning. This could impact 800,000 workers and could also delay the release of important economic data this week. The second is Italian political risk. The centre right PDL party ministers in the fragile coalition were pulled from the government last night. This crisis all boils down to the Senate vote later this week on whether to expel former PM Berlusconi from the Senate permanently. In retaliation he has tried to dismantle the coalition government, and tried to unseat PM Letta from his position.

Could Italian risks be overdone?

Looking at Italy first, the key date is Wednesday 2nd October, when PM Letta is scheduled to seek a confidence vote from the Parliament. If he gets a vote of no-confidence then it could trigger fresh elections, and most likely a bout of risk aversion in the markets. To win this vote, and thus avoid fresh elections, he will need the support of Berlusconi party members, who will have to deviate from the party line to support the government. Right now the risks of a collapse of the government and fresh elections are fairly balanced. There is some expectation that the a few PDL parliamentarians could vote in support of Letta out of frustration with Berlusconi’s antics. If Letta can scrape through a vote of confidence then the coalition may live to fight another day. However, the bigger result could be the avoidance of a credit rating downgrade. Standard and Poor’s cut Italy’s rating in July to just two notches above junk and political instability could trigger further cuts in the near term, pushing up Italy’s borrowing costs and triggering another flare up of Europe’s sovereign crisis.

So far on Monday, Italian stocks are lower for the third session, bond yields have been rising but the 10-year yield seems fairly contained, and remains around the 4.5% level. 4.65% then 4.93% - the high from 26 June, are key levels to watch on the upside. Above here could see a new paradigm for Italian yields and potentially a new flare up of the sovereign crisis.
The bigger problem with Europe’s sovereign battles of the last few years has always been the contagion effects. Spain is in the firing line if Italy goes down. So far the spill-over into the Spanish bond market has been fairly limited and the 10-year yield remains below levels reached in early September. The bond market is not in the danger zone yet, but if Letta does not win his confidence vote on Wednesday (the same day as the ECB meeting) then we could see a sharper reaction in the bond markets. Overall, the markets seem to be expecting a resolution from the Italian crisis, after all, political risk in Italy is nothing new…

Markets lose faith budge wrangle will be resolved

The markets are also well-versed in US budget wrangles, but this time it seems like a shutdown could indeed be on the cards. Back in 1996 non-essential government services were closed for 3 weeks. That is a long time without a pay cheque, and if something similar happens 17 years later it could easily disrupt this fragile economic recovery. Retail sales, consumer confidence, employment stats and even housing data could all be impacted by Congress’s stand-off.

US/Italian fears break the spell of stability

The markets have been used to a fairly sanguine political and economic environment in the last two years, so as we start a new week (and one which also coincides with month and quarter end) traders and investors may decide that these political uncertainties are not with waiting for and rush for the exits. After all, if you had been invested in the S&P 500 over the past year you would have been up nearly 40%, so taking profit may have been on your mind anyway.

Recent events on both sides of the Atlantic are a keen reminder why markets are right to hate politics. Politicians are unpredictable, as events in Rome and Washington remind us, and they yield unexpected consequences. The US Congress shutdown has a spill-over effect of its own: 1, how will it affect the debt ceiling debate, the US needs to raise its debt ceiling or face bankruptcy in the next few weeks, and 2, how will the disruption to economic data, particularly labour market data, impact the Fed’s tapering plan? A government shutdown coupled with concerns about the debt ceiling could put tapering to bed for some time.

Looking out for signs of panic

While it is impossible to know what will happen in the next few days, there are a few things that could suggest market concerns– firstly, a spike in the Vix index back to the highs from late June (currently the index is at 15). The second is Treasury yields; they have declined once again today and are testing 2.60%. If market fears escalate then we could see further downward pressure on Treasury yields (upward pressure on prices), which could see back to the 100-day sma at 2.50% and then 2.45% - the low from 22nd July.

US debt problems may not be dollar positive this time

So what about the dollar? Usually, US fiscal issues have, somewhat ironically, can lead to an increase in buying interest in the dollar because of its liquidity. However, if the budget crisis and a debt ceiling debate threaten to delay Fed tapering then the next few weeks could actually be dollar negative. The dollar index remains in the doldrums, and is hovering just above 80.00 – the lowest level since February- at the time of writing. When markets start to panic then traders search out liquidity, hence why demand for US Treasuries tends to rise. With Europe’s Italian problems, Japan’s sales tax and potential for a large stimulus package, domestic issues could limit EUR and JPY upside. This leaves the GBP.

GBP’s attractiveness could increase

It has liquidity, and compared to other major economies, it is fairly politically stable and growth has been turning a corner. GBPUSD reached its highest level since January after the September FOMC meeting, since then it has re-tested the1.6180 resistance level as political risks hit the market. Pullbacks from this level have been shallow since the FOMC meeting, suggesting that there is no appetite to push the pound higher. If we do see an escalation of Italian and US political risks then sterling could attract more safe haven flows. Above 1.6180 opens the way to 1.6380 – the high from the start of January, and the highest level of the year so far. There is also a lot of UK data out this week; a positive surprise in the PMI data for September could exacerbate upward pressure on the pound.

Thus to conclude, external political woes could be the bigger driver of GBPUSD this week. As we approach key resistance, a fundamental trigger such as a US government shut down on Tuesday could be enough to get us over this hurdle and at this point fresh 2013 highs could be on the horizon.