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EUR edging closer to moment of truth

The tectonic plates could once again be shifting in the Eurozone with the Italian electorate rebelling against austerity measures, which are at the very heart of the zone’s policies to impose budget discipline and to sustain the EUR. For the European Central Bank this could see it face a serious dilemma further down the road.

The chances are that the main parties in Italy will now try and form a coalition government, but given their disparate views it could prove unstable and indecisive. But in the short-term that would likely be seen as a positive for the EUR.

However, it would not be surprising if Italians aren’t back to the polls within months if the coalition partners can’t get along. Second time around voters could provide enough backing for a political party, which wins enough seats to decisively reject austerity and economic reforms and that would be deeply damaging to the EUR.

EUR/USD chart – it’s fate in the hands of Italian voters?

EUR USD Chart - Click image to enlarge
EUR USD Chart – Click image to enlarge

It would no doubt see yields of peripheral Eurozone bonds soar requiring the European Central Bank to unsheathe it’s Outright Monetary Transactions programme.

However, OMT comes with conditions attached for beneficiary states, such as promising to impose those much hated austerity measures. But could the Eurozone or the ECB allow Italian bond yields to soar to the point that the country could no longer fund itself even if it ditches austerity? Given the political situation in Europe this question is not as academic as it sounds.

It would set the scene for a nerve wrecking game of chicken, which Italy would very likely win, because the alternative would be Armageddon. An Italian default would be catastrophic for Europe’s banks, particularly those of Italy and France, but would anyway trigger a domino effect, which would rapidly escalate to a global banking crisis. It would also probably mean the end of the Euro.

However, it has not reached that stage – yet. Because it does look like it is only a matter of time before the ECB is forced to confront that dilemma. Any hint that the ECB was supporting the bond market of a country pursuing a lax fiscal policy would play very badly in Germany, which faces a general election itself in September. It would conjure visions of Weimar republic type money printing and hyper-inflation, which deeply scarred the German psyche.

But if this dilemma did come to pass the ECB would no doubt find an indirect way to address the issue, probably by supporting buying by commercial banks. It has if anything been fairly imaginative in its attempts to support the EUR within the confines of its narrow mandate.

The take away is that any election in a peripheral Eurozone country risks triggering a sell-off of the EUR. The depression in many peripheral Eurozone economies combined with social cohesion unravelling could see unstable governments leading to more frequent elections and the rise of extremist anti-European parties.

Leaps in Eurozone integration usually come about as a result of crises, however, the abandonment of austerity in the peripheral Eurozone combined with the prospect of outright money printing by the ECB could prove one crisis too far.

Justin Pugsley

Justin Pugsley

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