Euro Gains Before Monti Unveils Labor Reforms - Will He Deliver?

Talking Points

• Euro Gains Before Italian PM Monti Unveils Crucial Labor Reforms
• US Dollar, Japanese Yen Sold as Market-Wide Risk Appetite Recovers

With little of note on the European data front, traders will be focused on Italian Prime Minister Mario Monti as he holds a cabinet meeting where he is expected to unveil a major labor reform package. The scheme is part of an initiative by Italy’s newly minted technocrat government installed last year to boost long-term economic growth. The hope is that laying the foundation for key structural reforms now will encourage confidence and reduce borrowing costs, keeping sovereign solvency fears at bay.

The ECB injected close to €1 trillion into the EU banking system via its 3-year LTRO operations in December and February. This meant that lenders had enough cash in their war-chest to offset losses on a simultaneous default of Portugal, Spain and Greece, meaning the likelihood of a market-wide credit squeeze in the event of a blow-up in any of the three countries became unlikely. The successful completion of Greek PSI that markedly trimmed Athens’ obligations meant LTRO money could stretch further still.

On balance, that left Italy as effectively the last major sore spot on the Eurozone debt crisis front, at least over the near term. Italy has the region’s second-highest debt burden relative to GDP after Greece and close to €3 trillion in outstanding government paper. That makes it the world’s third-largest bond market, so significant stress there would have dire implications well beyond the borders of the single currency bloc. With that in mind, the ability of the Monti administration to push through its reforms is critical to maintaining the lid on debt crisis fears.

The Prime Minister faces an uphill battle as labor unions mount fierce opposition to the reforms. Some of the proposed changes are tipped to include provisions to make it easier for employers to fire workers by stripping courts of the ability to reinstate terminated employees, limiting compensation to about 1 – 2 years of salary in cases of wrongful dismissal.

The markets seem relatively confident after the Monti cabinet passed their austerity measures through the lower house of Parliament yesterday. Benchmark 10-year Italian yields are hovering near seven-month lows and the Euro is firmly higher. The chipper mood has spread to the spectrum of risky assets, with S&P 500 stock index futures on the upswing and the safe-haven US Dollar and Japanese Yen broadly sold. Optimism may prove fleeting however if policymakers unveil a watered-down reform package that rekindles fears about Italy’s fiscal outlook.

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--- Written by Ilya Spivak, Currency Strategist for Dailyfx.com

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