It's a bit too soon to hop on the euro relief rally bandwagon

The euro has lurched into relief rally mode on the news that the Italian populists have abandoned their efforts to form a government after Italian president Mattarella rejected their eurosceptic choice for finance minister. But how this provides any sustainable relief in the situation is entirely unclear. 

For the near term, the appointment of a caretaker government until new elections would cap the immediate prospects of a further credit spread widening, but eventual new elections could actually strengthen the mandate for the populists, who have an even more compelling case for pointing out the threat to Italy’s sovereignty from its use of the euro. 

Alternatively, the situation could devolve into a constitutional crisis via an attempt to impeach the president. In short, the situation is far from over and any relief could prove short-lived and reversed by the next headline.

The other elephant in the room is the decline in US yields since the publishing of the Federal Open Market Committee minutes last week, a development that has altered the playing field across asset classes, as the 2.95-3.05 pivot zone break in the US 10-year benchmark now appears to have reversed. In FX, this development has most immediately impacted the rate-sensitive USDJPY, which has reversed hard from its recent rally highs. Some of the JPY bid last week may have been down to EU existential stress and EM volatility, but US rates are an important driver.

Elsewhere, EM currencies have generally caught a relief bid, with the Turkish lira even trying to right itself this morning, but emerging market assets are not doing well and our measures of risk aversion are not at all supportive at this time as covered in our most recent EM FX Weekly. So, if the reversal in long yields is down to weak risk appetite and weak growth prospects, this is not likely to support risky assets as only a return of “Goldilocks” (sidelined yields as economic growth chugs higher with no inflationary implications) would likely do so.

Chart: USDJPY
USDJPY has reversed hard from its recent highs well above 111.00, with the reversal in global yields likely the chief contributor, although EURJPY action late last week may have also been a flow-driver on the euro’s existential distress. If US yields are capped for the cycle, especially at the long end, this may provide a cap for USDJPY as well and drive the pair back into the lower range as long as we remain below the pivotal 110.00-25 area.

Remember that today is the US Memorial Day holiday and markets will be closed there as well as in the UK for the May UK bank holiday. For the week ahead, besides the fully energised situation in Italy and ad hoc headline risks that will likely impact the market all week, we focus on CAD, where the Bank of Canada may err on the side of caution in its guidance, given the recent focus on macro-prudential efforts putting the brakes on the economy and the very steep decline in oil prices (lots of focus on OPEC/Russia news cycle after last week’s indication that they would like to boost production – the next key meeting is not until late June). US-Canada yield spreads have been locked in a very tight range.