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Euro at Risk as Italy Prepares to Unveil Budget

Euro at Risk as Italy Prepares to Unveil Budget

Dimitri Zabelin, Analyst

TALKING POINTS –EURO, ITALY, BUDGET, BONDS, EUROPEAN UNION

  • Political risk in Italy heightened amid budget talks
  • Italian coalition government show signs of fracture
  • Investors hold breath awaiting Italy’s 2019 budget

EURO FELL AS LEAGUE, M5S PREPARED TO LEAD ITALY

On June 1, the nationalist Lega Norda (League) and populist 5-Star Movement (M5S) parties fused together to create a coalition government led by Prime Minister Giuseppe Conte. Leading up to the formation of this adminisration, the Euro tumbled amid the uncertainty about its fiscal agenda. Yield spreads between German and Italian bonds also widened, reflecting the added risk of lending to the latter versus the former.

ITALIAN GOVERNMENT AT ODDS ON FISCAL PATH

The Italian government has to set out its deficit and debt targets by September 27. Deputy Ministers Luigi Di Maio of the M5S and League leader Mateo Salvini are both keen on increasing the deficit between 2.0-2.5% in order to pay for their electoral promises. These include substantial tax cuts and providing a universal wage.

However, Economy Minister Giovanni Tria – a firm believer in adherence to EU fiscal laws – is hesitant to implement the policies. Italy’s astronomical debt of 132% of GDP is a significant factor influencing Tria’s stance on spending. Markets could see that number increase alongside the probability of a government default. Internal friction is likely to rise as the deadline approaches, prompting markets to tense up.

This comes on top of an exposure of a secret plan to curb the fiscal radicalism of Di Maio and Salvini. Italian President Sergio Mattarella and Conte are working with Tria to bring down the projected increased deficit by watering down some of the two party bosses’ policies.

However, Di Maio and Salvini – despite implementing minor reforms – are still aggressively pushing their fiscal agendas for one compelling reason: their political legitimacy depends on it. If their policies are too modified and no longer reflect their campaign promises, their credibility as an anti-establishment and action-oriented government will likely deteriorate. This would almost certainly cause a drop in their popularity, disappointing Italians who pointedly voted against the status quo.

ITALIAN BUDGET MAY SINK EURO, SOUR BROADER MARKET MOOD

Markets – for the time being – appear optimistic that the budget proposal will adhere to and respect EU fiscal laws. German bonds have been falling while Italian ones have risen amid hopes for a fiscally responsible proposal.

This pattern may see a reversal as the deadline approaches and markets gauge the resolve of the Italian government. The Euro may experience greater than usual volatility leading up to and following the talks.If the budget proposal falls short of investors’ expectations, the spread between German and Italian bond yields is likely to rise. The single currency may fall, with potential gains to be seen in regional alternatives such as the Swiss Franc and British Pound. The anti-risk Japanese Yen and US Dollar may also rise amid broader risk aversion.

Movement of German and Italian 2-Year Bonds

German and Italian 2-Year Bonds - Daily Chart

ITALY MAY SET PRECEDENT FOR FUTURE EU INSTABILITY

Looking further ahead, Italy’s budget proposal is due at the European Commission by October 20. If regional authorities take a more lenient stance on adherence to fiscal rules, a significant precedent will have been set.

If a looser fiscal plan is approved, many Mediterranean states who have suffered from economic downturns will question why Brussels did not make similar exceptions for them. It may also incentivize other anti-establishment governments and parties to propose bolder policies, using Italy as an example of fiscal exceptionalism.

European politicians channeling seething frustration with the structural framework of the EU have made increasing headway in recent years. Critically, Brussels’ approach to Italy’s finances may amplify such rhetoric ahead of EU Parliamentary elections in May 2019. If eurosceptics win greater representation, that will almost certainly amplify political fragmentation at the expense of financial stability.

EURO TRADING RESOURCES

--- Written by Dimitri Zabelin, Jr Currency Analyst for DailyFX.com

To contact Dimitri, use the comments section below or @ZabelinDimitrion Twitter

DailyFX provides forex news and technical analysis on the trends that influence the global currency markets.

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