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The very sharp turn-around in the Italian bond market after Tuesday’s panic has certainly bred an atmosphere of relative calm across the markets as yesterday’s rally in EUR/USD has been extended, through the break above the 1.17 level has so far today not held, explains Jane Foley, Senior FX Strategist at Rabobank.  

Key Quotes

“At this juncture there are no guarantees that the better market sentiment will sustain.   Even if another election is avoided in Italy, investors will have to acknowledge that the electorate have demanded change that is unlikely to be compatible with the fiscal rules of EMU, and that this circumstance is unlikely to be altered whether or not there is a return trip to the polls.”

“Currently the ball is back in the court of the League and the Five Star movement to see if a coalition can be formed. Salvini yesterday was opposed to changing the proposal of Euro-sceptic Savona for the next Finance Minister.   While the market will be relived if a government is formed soon, investors are likely to be very wary if Savona takes this key office.   Even if Savona is shifted into another position, investors are likely to remain concerned about how the populists will impact the budget outlook.”

“Late last Friday, Moodys’ put Italy’s credit rate on review of a downgrade based on concern that the policies of the populist coalition could be inconsistent with a sustainable downward trend in the country’s debt ratio.”

“The events of the past few days has freshened the debate as to the role of the ECB in the event regional crisis. ECB President Draghi is closely linked with his pledge that he will do whatever it takes to save the EMU project.     There is the OMT.   This has never been used, but it would allow the ECB to make large scale purchases of Italian debt.   Crucially, however, a country would have to apply for this and swallow the conditions that require economic reform, which Italy’s populists oppose.”

“For now, speculation is emerging in the market that given the headwinds associated with Italy, that the very dovish tone of the ECB is likely to remain in place for an extended period – we see no rate rise before September 2019.   This brings us back to a key reason why we favour further downside in EUR/USD.   Even if the cracks in EMU are papered over in the short-term, interest rate differentials still favour the USD.   We have revised down our 12 mth forecast for EUR/USD to 1.12.”