EUR: Limited Italy reaction masks building risks - MUFG

Derek Halpenny, European Head of GMR at MUFG, suggests that perhaps the resilience of the euro in the wake of the referendum defeat for PM Renzi in Italy implies upside risks for the euro over the short-term.

Key Quotes

“ECB President Draghi has a tricky task tomorrow with the economic data from the euro-zone indicating a pick-up in activity. Last week, the euro-zone unemployment rate fell to 9.8% - an important development given it is the lowest level since July 2009 before the debt crisis in the euro-zone. The 9.8% level also indicates that the ECB is being too pessimistic itself. The current ECB forecast for unemployment in 2017 is 9.9% and 9.6% in 2018. The ECB is set to revise those forecasts lower tomorrow. Then yesterday, German factory orders for October revealed a 4.9% m/m surge, the largest since July 2014 and reinforcing the view of the Bundesbank that German GDP will pick up significantly in Q4.”

“But while the euro may be deriving support from some signs of cyclical improvement for the euro-zone economy which may curtail the dovishness of the ECB tomorrow, the return of fragmentation within the euro-zone financial markets, if sustained will be a far more important driver for the euro going forward. The Target 2 data highlight the worsening divergence within the euro-zone that is prompting a notable shift in capital from Italy and Spain in particular. The liability level for Italy under Target 2 has surpassed the levels reached during the debt crisis and we can only assume that ECB QE is helping to limit a greater divergence in yields between Italy and Germany. Italy’s Target 2 liability is about 20% of GDP despite Italy running a current account surplus of 2.6% of GDP and a primary budget surplus of around 1.5% of GDP.”

“The real fundamental problem is the lack of growth in Italy. Real GDP in Italy remains around 7.5% below the pre-crisis peak set in Q1 2008. On the same measure, real GDP in the US is 11.5% higher and in the UK, real GDP is around 8.0% higher.”

“For this reason, the need for the ECB to announce an extension in QE beyond March 2017 seems obvious to us. Even though the cyclical picture for the euro-zone economy looks to be improving, more serious problems related to the cohesion of the single market could be brewing. Given the escalated political uncertainty, now doesn’t appear to be the time to signal an end of ECB support that is clearly helping to stabilise financial markets in the euro-zone. We do not expect the resilience of the euro to persist whatever the outcome of the ECB meeting tomorrow.”