The Day after Draghi

The FX markets kick off the week on an extremely chaotic note. Both the pound and the euro are being severely punished for the political decisions that are taken in the UK and in Italy respectively.

Italy turns right

As expected, the far-right candidate Giorgia Meloni won a clear majority in Italy at yesterday’s election, with Brothers of Italy gaining more than 25% of the votes, versus only 4.4% back in 2018. And Meloni’s right-wing alliance with Salvini’s League and Berlusconi’s Forza Italia got around 43% of the votes: the terrible consequence of the pandemic, the war and the energy crisis.

It’s clear that Meloni’s future government will face a bumpy road as the energy crisis is looming, inflation is skyrocketing, the interest rates will be rising steeply, while the euro keeps falling – a part of it being due to Italy itself – and cherry on top, recession is where the continent is headed to.

Of course, Italy’s most problems are true for any leader that would take the reins of the country, but the biggest concern for investors regarding Meloni, is whether the new far-right Italian government would deviate from the reforms that Draghi put in place, which actually helped Italy get the EU on its side – given that Draghi knew well how to dance with the rest of the Europe. The same is not true for Meloni.

Britain has been an excellent example of the lone sheep being in danger of the wolf.

The EURUSD has been shattered this morning. The pair dived to 0.9550, and will certainly remain under the pressure as the Italian yields will likely detach from the rest of the EZ and run toward the north. The wider yield spread between Italian and German bonds will likely continue pressure the euro lower.

As a result, the European Central Bank should get more aggressive on its rate policy to stop the euro’s crumbling. But it may not get the euro’s back fast enough to avoid inflation spiral higher.

And the cherry on top, the PMI figures released last Friday were less than unpromising. The euro-area private-sector activity shrank for the third straight month due to rising inflation, and energy costs. And the latest PMI suggests that the European economy will shrink 0.1% this quarter, and the things get uglier to the end of the year.

Across the Channel, it rains even more

But it’s almost worst across the Channel, if that’s any consolation. Investors really hated the ‘mini budget’ announced in UK last Friday. Investors were expecting to hear about a huge spending package from Liz Truss government, but the package has been even HUGER than the market expectations.

The UK announced a £161 billion package that includes the biggest tax cuts since 1972 – around 50% more than what investors anticipated. The energy bill will cost the UK around £60 billion within the next 6 months, to hopefully provide the UK with a 2.5% annual growth rate.

This is what the politicians are telling.

What the market is hearing is: who will finance this spending? UK’s 10-year yield jumped more than 20% since last week.

If the reaction in the sovereign yields is normal, the market reaction in equities and in pound are disquieting.

Normally, you would’ve expected a huge fiscal spending package from one of the biggest economies in the world to at least boost the equities and the pound. It could’ve boosted equities because the amount of money that will be pushed into the system should start going around the economy, and in businesses’ pockets, and spur growth. But the FTSE dived near 2% on the news.

And it should’ve boosted sterling, because such a huge fiscal spending would result in a decent response from the Bank of England, which is now expected to respond with a 100bp hike at its next meeting to make sure that inflation doesn’t go out of control due to tens of billions of pounds that will flood the system. But the pound’s just gone under the water. Cable tanked below 1.0350 in Asia this morning. Parity is seen as almost certain.

And what does the UK’s Chancellor of Exchequer say to investors? ‘The market will do what they will’!

The only hope here is to see at least a sugar rush in the British economy to help investors digest information, but the next couple of years will probably be harsh for the UK.

Has anyone seen the US dollar?

The dollar index took a lift, and the dollar index is just crossing above the 114 mark at the time of talking.

Gold dived to $1626 on the back of soaring US dollar.

US crude oil plunged below $80 per barrel on the back of rising recession worries as the European continent seems to be going into a coma before winter. Of course, OPEC can do nothing about the cheaper oil, as what’s driving the market south is the worry of a bad recession looming.

The S&P500 tanked to the lowest levels since this summer but is still above the summer dip, whereas the Dow Jones has cleared the 30’000 support and is now below the summer dip, and is now at the lowest levels since November 2020.

The futures hint mostly at a bearish start, even though the FTSE futures are slightly in the positive this morning. But the mood is sour. Goldman Sachs slashed its year-end estimate for the S&P500 to 3600 from 4300.

I now start thinking, if both the equity and sovereign markets fall this dramatically, the Federal Reserve (Fed) will not be given the choice to continue tightening as aggressively as planned, even if inflation doesn’t come down at the speed the US policy makers are aiming for.

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