Although the markets are fixated on the USDJPY and its latest test of the key 100 level, the political impasse in Italy is now closer to resolution, which is a resoundingly positive development for the euro.
While most market participants are focused on whether USDJPY will break 100 this morning, we are much more interested in how this weekend's Italian Presidential election and European Central Bank (ECB) comments will affect the euro.
After five unsuccessful rounds of elections, Italy finally re-elected Giorgio Napolitano as President. The 87-year-old politician is the first in Italy's history to serve a second term in this role, and the decision by the electoral college to bring back the old guard is a sign that the current political groups prefer to form a new government than hold new elections for Prime Minister.
The euro gapped higher on the news when the FX markets opened in Asia, but the gap has since been filled. The euro is now trading lower against the US dollar as concerns about ECB easing return.
Before we explain why the odds for ECB easing have increased, it is important to discuss Italy's political situation further, as the decision on a President removes a major short-term destabilization risk for the euro. It is no secret that Napolitano prefers forming a government instead of holding elections, and the fact that his re-election was supported by a large coalition of parties is a sign that the political groups also want to avoid messy elections.
Pier Luigi Bersani's inability to gather support for his two candidates forced him to resign as the leader of the Democratic Party, which now needs to nominate a new leader who will likely be more amenable to working with Napolitano. In fact, local papers are saying that Napolitano agreed to a second term on the condition that the parties will work on forming a government. The re-election of Napolitano and the departure of Bersani gets Italy one step closer to resolving its political fiasco, which should be great news for the euro.
The EURUSD, however, was moving towards 1.30 this morning because more European Central Bank officials sound like they support the idea of a rate cut or some form of additional easing from the central bank. As we mentioned before, the ECB has a history of preparing the market for major changes in monetary policy through a consistent shift in tone by policymakers. Last week, Jens Weidmann said the central bank could cut interest rates if new information warrants it, and over the weekend, ECB member Jorg Asmussen also said "the effectiveness of rate cuts is limited, but it’s still possible to do this if data justified it."
ECB member Klaas Knot repeated a sentiment shared by ECB President Mario Draghi at the last monetary policy meeting. He said that the "latest round of forecasts of the data coming in have shown that the risks are on the downside." As a result, this week's Eurozone PMI and German IFO reports will play a central role in setting expectations for ECB policy, as well as help decide whether the EURUSD maintains a break below 1.30.
There are no major US economic reports today except for existing home sales, which is scheduled for release this morning. We don't expect this housing report to have the power to drive USDJPY above 100.
By Kathy Lien of BK Asset Management
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