The bank could choose a longer timescale over which it must reinvest maturing debt, alter the length of maturities it holds. It can change the countries in which it makes its purchase. If it decides to pivot away from any of these options, the bondholders would adversely react to this.
The unprecedented move by the European Commission, Europe’s administrative body, didn’t surprise the forex market yesterday because it was widely expected. The European Commission for the first time in the history asked another member state to resubmit their budget plans because it violated the block’s fiscal laws. Italy has had several warnings from the EC to reduce its budget but it doesn’t like to live within its means. Italy has expanded its expenditure beyond its boundaries and the populist government has refused to take austerity measures. The budget submitted to the EC proposed a deficit equal to 2.4 percent of GDP (more than double the eurozone limit). This is way too high for the EC because Italy’s debt equals 131 percent of GDP.
The European Commission simply refused to accept it and now Italy will have to make changes to it. Whether the country complies, remains to be seen. This is because the new Italian government needs to deliver on its promises and for that to become a reality, it needs to put up a fight with the EC. The government has made it clear that it has no desire to step down from its main agenda. Nonetheless, the EC’s rejection of Italy’s budget is going to create an adverse environment for the Italian banking sector in the coming days.
Going forward, the spotlight is on the European Central Bank’s monetary policy scheduled for tomorrow. What will the president of the European Central Bank, Mario Draghi, say about Italy? This is the question which many are asking. Under the current proposed budget, the country’s economy will suffocate, pushing the third biggest economy of the eurozone in recession. The gravity of economic reality will likely trigger another major crisis for the eurozone. This is at stake and this is the major agenda for the president of the ECB. His views on Italy will be scrutinised by currency and bond traders.
I expect Mario Draghi to say that he doesn’t see any risk of contagion due to the Italian drama and that the ECB will continue its path on monetary policy normalization. This would be a bullish message for currency traders and we could see upticks coming for the euro-dollar pair. A bullish confirmation or an upward trend confirmation would only commence if the euro-dollar pair breaks the level of 1.1630.
Having said this, the ECB’s upcoming decision could impact the Italian bond market. The ECB would have to decide on its asset purchases as they become due at the end of the year. Italian bonds may have the most to lose, especially when they are the biggest beneficiaries of the ECB’s decision. The bank could choose a longer timescale over which it must reinvest maturing debt, alter the length of maturities it holds. It can change the countries in which it makes its purchase. If it decides to pivot away from any of these options, the bondholders would adversely react to this. But the actual changes, if they do take place, will only be coming at the December meeting.
Remember, Draghi pushed the euro higher last year in September when he described the inflation pressure as relatively vigorous. But the Italian concerns have started to push the currency lower since then. I am expecting Draghi to stand by his inflation stance and this would support the euro. There is no doubt that the growth equation has started to disappoint due to internal and external factors but, in relative terms, the improving growth and inflation picture should be able to battle out the negative impact from political risk. Thus, I am expecting the ECB to maintain its monetary policy stance, and this would help to put a floor under the euro.
Draghi’s remarks are going to bring a direct move in the Eurozone’s currency. He will need to craft his speech and choose his words very carefully tomorrow. A dovish message could push the euro below 1.14 against the dollar. This is the key support area so far and the next one is near 1.12.
