January 19, 2017    4 minute read

Post-Italian Referendum: Where is the Euro Headed?

Danger Ahead?    January 19, 2017    4 minute read

Post-Italian Referendum: Where is the Euro Headed?

As the eurozone’s third-largest economy, Italy exerts significant influence on the EU’s stability and success and, despite its sluggish economic growth and falling productivity following the financial crisis in 2010, on the value of the free floating euro currency.

Dip and Recovery

November 2016 saw the worst performance of the euro against the pound since the financial crisis, as impending political risks diminished confidence in the eurozone’s survival. This was largely driven by political uncertainty surrounding several of the EU’s founding members since the Brexit vote in June damaged the UK economy less than anticipated.

Italy’s situation was a primary focus during this period as Renzi’s proposed reform regarding the shifting of power to the Chamber of Deputies over the Senate would have opened the door to a number of Italian banks, most notably Monte Dei Paschi, being rescued by a €5bn injection from the ECB due to a more streamlined legislature.

The ‘no’ vote on December 5th, however, left the government no choice but to eventually bail out the bank for €20bn in late December. The euro fell immediately to $1.05 following the election but recovered quickly from the blow to 1.07$ after the election, unlike Italian 10-year Treasury bonds and Italian bank shares whose prices tumbled.

The ECB’s decision in the second half of December 2016 to extend its Quantitative Easing programme until the end of 2017, three months more than expected, albeit cutting monthly payments from €80bn to €60bn in March, was an indication that rates in the Eurozone are likely to remain flat for some time.

Conversely, the Fed’s rate hike by a quarter percent on December 14th caused upward pressure on the dollar that combined with the downward pressure on the euro from the news, led the euro/dollar pair to fall to almost parity with the dollar at $1.0355 on December 19th, following a small surge the week before the ECB meeting when investors’ outlook on the meeting’s outcome was more positive.

The euro has been sustaining a short rally as political turmoil priced in during November and December has been deemed overextended and thus gradually lifted, and the dollar rally slowed down since December.

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(Source: Reuters)

Is Italian Populism a Threat?

The rise in popularity of the Five Star movement raised doubts regarding the resilience of the European Union following Renzi’s resignation, as it is a strong advocate of holding a referendum on Italy’s membership of the euro currency. Other opposition parties such as Forza Italia and Lega Nord have also been taking an anti-euro stance, and since the structure of one of the most democratic governments in the world has remained intact, it is likely that one of these parties will eventually rise to power as the Democratic Party does not hold an overwhelming majority. The Italian constitution does not currently allow for a referendum on dropping the single currency, but rapid political changes could well cause alterations given Italy’s 5% decrease in factor productivity since adopting the euro in 1999.

Fear of an immediate change in parliament subsided shortly after former Foreign Minister Paolo Gentiloni took over from Renzi as Italian Prime Minister following a confidence vote, re-establishing some steadiness for the Italian government as the Democratic Party retains control at least until the elections in early 2018.

The Euro’s Future

The currency pairs euro/dollar and pound/euro have been subjected to large moves atypical of Foreign Exchange markets as recent political developments in the UK and the US have led to changes in trade agreements and fiscal policy whose effects will certainly cause their respective currencies to fluctuate in value for the foreseeable future.

In the short term, the euro is unlikely to outperform either of these two currencies, but the Brexit “ultimatum” in March will cause directional volatility even though the outcome of a ‘hard’ Brexit is likely to be already priced into the pound to a large extent.

However, the threat of Italy leaving the eurozone remains low in the short term, so the euro is unlikely to fall below the dollar in 2017 due to Italy alone. On the other hand, surprising results in elections in Germany and France may bring about major moves in the euro relative to the dollar.

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