EURO Points to The Downside As Italian Bond Yields Rise

Last week's extreme volatility in global equities markets have settled somewhat as the new trading week begins. The US dollar has traded in a narrow range during the Asian session as the haemorrhaging in regional stock markets has slowed. 

While most Forex traders were focused on the impact of the equities driven "risk off" in the major pairs last week, we noticed the sharp increase in the spread between Italian 10-yr BTPs and the German 10-yr Bunds.

During the course of last week, the yield on the BTPs rose 25% from 2.85% to a 4-year high of 3.60%. At the same time, the Bund yields slipped from 57 basis points to 49 basis points. The significance of this move should not be underestimated. Over the last 6 months, the inverse correlation between the BTP/Bund spread widening and the EUR/USD falling is over 80%.

Italian budget

The main reason for the pressure on the Italian debt market stems from the battle between the EU and the Italian government over the size of the projected deficit in Italy's proposed budget, which currently is near 2.4% of Italy's GDP.

The ruling Italian coalition is scheduled to submit its budget to the EU either today or tomorrow. The draft budget sent last week has already been met with an icy response from the ECB as well as top officials in Brussels. We don't expect this budget negotiation to be swift or easy. The process can go back and forth for weeks without a policy agreement, which will not be bullish for the single currency. 

We calculate that if the negotiations get off to a bad start, and BTP yields push up to 4%, the EUR/USD will break down through the mid-August lows of 1.1345 and could possibly extend to 1.1170.

On the other side of the coin, the technical momentum indicators for the EUR/USD suggests some consolidation between 1.1480 and 1.1625 over the next few days.

USD/JPY

The USD/JPY traded lower every day last week. This isn't surprising in a "risk off" environment. The RSI and MACDs don't reflect a bottoming pattern and the next key support area is in the 111.25 area. At this point, only a move back over 112.60 would reverse the technical picture.

GBP/USD

We are looking for entry points to re-establish a short position in the Sterling. Friday's sharp reversal now reflects a slightly oversold pattern on the 4-hour charts. With Brexit chatter still dominating trade flow, the GBP/USD could recover into the 1.3200 handle sometime today. 

AUD/USD

The AUD/USD rose over 1% last week and remains firm into the London session. We expect to see resistance in the .7150/60 area before extending the establish downside trend. The key support level on the daily chart is at .7080.