Italian concerns continue to weigh on sentiment

European stock markets continued to struggle first thing this morning – despite a sharp rebound for Chinese markets overnight – as the yield differential between 10-year Bund and BTP widened further amid ongoing concerns over Italy's budget proposals. The selling of Italian bonds rippled through to other Eurozone markets with yields on 10-year Spanish debt, for example, hitting its highest level since March 2017. However, at the time of writing, the stock markets were coming off their worst levels amid short-side profit-taking ahead of the weekend, and as investors awaited direction from Wall Street which sold off yesterday. In FX markets, meanwhile, the EUR/USD almost touched last week’s low at 1.1430 before bouncing back slightly. The single currency fell most significantly against the New Zealand dollar. Most other euro crosses were weaker at the time of writing.

Figure 1: Italian-German 10-year bond yield differential

EUR/JPY could suffer if concerns escalate  

The EUR/JPY was an exception, which was showing apparent strength despite the stock market weakness. But appearances can be deceptive. Indeed, this particular euro pair actually made its move first when it fell sharp sharply yesterday. So if the stock market weakness persists and safe haven flows for the yen continues then the EUR/JPY could be among the first euro crosses to extend its decline further, despite today’s bounce.

EUR/JPY’s path of resistance to downside despite its bounce today

Technically, the EUR/JPY’s failure to hold above the old high at 131.95 around the start of the month was the first major warning sign that rates might sell-off following that fakeout. Indeed, the EUR/JPY has drifted lower since then, making a series of lower lows and lower highs amid the ongoing bearish fundamental backdrop (stocks selling off because of trade concerns and China, and amid Italian concerns). Most recently, the EUR/JPY went into a consolidation mode below a critical resistance level around 130.15 and support at 129.20. But yesterday, the buyers lost control and rates broke out of this range to the downside. Thus the path of least resistance remains to the downside for now.

Going forward, the 129.20 level is going to be very important. For as long as the bears hold their ground here, they will remain in control. But if this level were to give way then things might start turning bullish again for the EUR/JPY, especially if it also goes on to make a higher high above that 130.15 level. But if the downward pressure remains, then the next immediate objective for the bears would be the liquidity resting below 127.90, followed by old resistance levels at 127.00 and then at 126.50.

Figure 2: