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A Profile for Euro Traders on the Italian Referendum

A Profile for Euro Traders on the Italian Referendum

Oliver Morrison, Analyst


Talking Points

  • Traders brace for volatility ahead of Italy referendum with Euro implied volatility at Brexit highs
  • The vote threatens to move forward the existential threat to the Euro-Zone
  • European banking sector also in the firing line

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Traders are braced for volatility when Italy holds a referendum on constitutional reform on Sunday. It’s the biggest event risk for the Euro since Brexit, and markets are jittery about the prospect of a ‘No’ vote. But why exactly has a vote on the peculiarities of Italy’s uncharacteristic parliamentary system become a – perhaps exaggerated – proxy vote on Italy’s membership of the Euro-Zone?

What’s the story so far?

April 2014 - Italy is ‘the sick man of Europe’, facing a host of deep-seated economic and fiscal problems. The energetic young Prime Minister Matteo Renzi wants to introduce legislation aimed at strengthening the stalling economy. But he complains that the country’s peculiar ‘perfect bicameralism’ parliamentary system, where both houses of parliament – the Senate and the Chamber – have the exact same powers, is hindering his proposed economic reforms. This system was brought about in the aftermath of the Fascist era under Benito Mussolini and was deliberately designed with a host of checks and balances in place to restrict the abuse of democratic power.

His solution? He and his centre-left Democratic Party introduce a bill to the Senate proposing amending the Italian constitution to make it easier for the government to pass laws. The reforms would substantially decrease the membership and power of the Senate. Renzi stakes his political career on the vote, promising to resign if there’s a ‘no’ vote.

October 2015 - The bill receives its first approval in Senate.

January 11, 2016- The bill receives its first approval in the Chamber.

January 20, 2016 - The bill receives its second approval in the Senate.

April 2016 - The bill receives its second approval in the Chamber. However, the constitutional amendment was not approved by a two-thirds majority of two-thirds in each house of the Parliament and a referendum is called.

It will be the third constitutional referendum in Italy’s history. A vote to give the regions more power was approved in 2001. In 2006, proposals by the Silvio Berlusconi government to give more powers to the Prime Minister were rejected by 61.3% of voters.

June 23, 2016 - Brexit. In the UK, 51.9% of Brits vote to leave the European Union. Markets had widely anticipated a vote to remain in the 28-nation bloc. The British Pound slumps to a 31-year low versus the Dollar following the vote, its biggest one-day loss in history. The Euro gains on the Pound, but EUR/USD falls from 1.14242 to 1.09119 on the day of the vote indicating the market’s concern that the UK may not be the only country that ultimately leaves a European economic alliance. That in turn amplifies the concern of populism rising in Europe to threaten the EU and the Euro-zone that anchors the common currency.

July 2016- The Italian vote is now seen as the next concentrated source of political risk in the Euro-Zone. Analysts say the referendum is the "single biggest risk on the European political landscape. An opinion poll shows that Five Star has overtaken Renzi’s Democratic Party to become the country’s most popular group. Five Star wants to hold a referendum on Italian membership of the euro, as do other main political parties in Italy. The media invents its next epithet: ‘Quitaly’. Investors begin toshow unease in the country’s assetsget spooked. Italian bonds are under-performing their Spanish peers for the first time in a year.

November 2, 2016 - Donald Trump beats the odds to be elected the next US President. Markets fear the Italy vote could, after Brexit and Trump, mark a third win for the ‘populist explosion’.

So what happens if there’s a ‘no’ vote?

A last look at the polls before the current blackout period showed the ‘No’ vote ahead, although the large ‘undecided’ contingent could still swing the vote the other way. Expectations for a ‘No’ vote on Sunday have already seen a range of Italian assets slump. If Renzi resigns and Five Star gains power through potentially difficult-to-establish alliances, its leadership has said it would hold a referendum to decide whether Italy should leave the Euro-Zone. Some analysts even fear that the threat of this key member leaving could put us on a path to the eventual breakup of the entire European Union.

The Italian banking system also hangs in the balance. Italian bank shares have been on a one-way trip over the last few months, with losses accelerating in the past few weeks. Investors are worried that if PM Renzi resigns, his proposed bank bailout may be scrapped, leaving the Italian financial system facing heightened risks. As is currently seen in the weak British Pound ahead of the UK government triggering Article 50 by the end of March 2017, markets can treat uncertainty harshly.

And if the Italian banking system faces a crisis, so does the rest of the European banking system. Beleagured Banca Monte dei Pashi di Sienna shares have nearly halved in just over a month, while the 10-year Italian bond yield has jumped nearly 60 basis point to 2.05% over the same time frame as investors demand more yield for their money. The Euro in contrast has fallen from around EUR/USD 1.10 to 1.06, though that move is in part due to the upcoming Federal Reserve meeting where a fed fund rate hike fully priced in at the December 14 FOMC meeting.

And what happens if there’s a ‘yes’ vote

If a ‘Yes’ vote prevails on Sunday, a bounce back in Italian assets and the Euro is expected, but this may just be kicking the can down the road. Reform via the specific 47 articles (of 139) in the Constitution does not halt the rise of populist discontent, solve banking system strains or recharge lackluster economic growth. Further, an election in Austria, also on Sunday, threatens a victory for the first far-right head of state in Western Europe since the Second World War.

There are also elections in the Netherlands, France and Germany all coming up next year, again heightening the political uncertainty in the Euro area.

What time does it all start?

The vote is on Sunday December 4. Provisional turnout results will come in around 07:00 GMT. The first exit polls will appear around 10:00 GMT. Currency markets in Asia open at 18:00 GMT on Sunday. The final result of the vote will start to come in around 01:00 GMT (02.00 AM local) on the morning of Monday December 5. The Italian bond market and stock market open at 07:00 AM and 08:00 (06:00 and 07:00 GMT) respectively.

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