Italy risks help GBP, and oil retreats as Saudi’s back down

The big move in FX overnight was the pound, which was the second worst performer in the G10- space, just behind the Swedish krona. The driver was none other than Brexit and more reports about deadlocked talks and slipped deadlines. The facts around Brexit haven’t changed at the start of a new week: there is still no deal, key issues are yet to be decided on and time is slipping by. Thus, it is barely a surprise to us that this knee-jerk reaction lower in the pound is in the process of being reversed.

Italy’s fight with the EU gets real

GBP/USD is back above 1.3150, after dropping to a low of 1.3086 at the open. EUR/GBP has also backed away from the highs at 0.8825, which comes as Italian 10-year bond yields have risen to another record high today at 3.58%. The pick up in bond yields is unsurprising given that Italy is due to present its budget to the EU today, along with all other EU nations. The current plans for a budget deficit of 2.4% is in clear violation of EU spending rules, and the collision course that Rome has been headed with the EU could come to a head this week. The EU/ Rome clash has already de-stabilised Italy’s bond markets, however the contagion to Europe’s other financially-challenged states has been weak. While Portugal and Spain have seen their yield spreads with Germany rise this month, it is worth noting that Portugal’s debt was upgraded to investment grade this morning by Moody’s, suggesting that this is a localised problem for Italy.

Why Italy matters

However, even if contagion doesn’t spread to other Eurozone nations, like it did during the peak of the Eurozone debt crisis, rising debt costs for Italy are a major issue for the EU for a few reasons: 1, Italy is the third largest economy in the Eurozone, so its financial fate is important for the entire bloc. 2, It has very strong trade ties with the rest of the EU, so Italy’s demise would impact the Eurozone in a fundamental way, which was not the case with Greece. 3, It is hard to see either side backing down over this budget. This puts the prospect of an Italian Eurozone referendum firmly on the cards, which is destabilising for all euro-based asset prices in the coming weeks. Thus, if Italy’s budget woes remain in the news then it is a risk to the value of euro-based assets.

Why Merkel won’t fall over easily

German elections, and Merkel’s ally’s high-profile defeat in Bavaria this weekend is also in the news today, however, we believe that this regional election doesn’t have too much impact on the direction of the euro unless the result causes Merkel’s coalition government to collapse. While Merkel will most likely be unseated from power, it won’t happen this week (we assume), she is a wise, old politician, and she has fought hard battles all her political life. Thus, this backlash from the voters will also be dealt with, in our view.

Why investor mood may be picking up

The European indices have managed to claw back some earlier losses as we have progressed through the morning, this has translated to US stock index futures. Earlier this morning, the Dow Jones futures contract predicted a near 200-pip decline at the US open, however, this has fallen to a 100-pip decline at the time of writing. There are signs of a slight pick up in risk sentiment at the start of the week, this could be driven by:  a slight decline in 10-year US bond yields, which has also caused the US yield curve to back up slightly, a decline in the price of oil after Saudi Arabia launched an investigation into the death of a prominent Saudi journalist in Turkey, thus potentially cooling tension between the US and Saudi. Also, earnings season in the US resumes today, with US banks expected to deliver another quarter of bumper profits, which may also be boosting sentiment.

A fresh week, with less risky challenges?

Overall, there are still multifarious risks that could impact the markets, including plenty of political risks, usually the hardest for the markets to digest, but a sell off like we saw last week does not seem to be on the cards.