Cautious enthusiasm for Italy’s budget gambit

The euro rebounded this morning on Italy’s latest move to shore up its fiscal credibility as the government claimed it could reduce the deficit projections slightly from 2.4% for both 2020 and 2021 to 2.2% and 2.0%, respectively. This comes after yesterday’s rather tough response from the EU side and the markets jettisoning of Italian BTPs, which took the 10-year sovereign Italian yield to above 3.5% and the 2-year above 1.5% at one point. This is a rather clever move, as it provides the optics of compromise without really putting anything new on the table, as budget projections rarely pan out anyway, particularly with new fiscal stimulus measures in the works.

The markets are cautiously hopeful, given the 2-year BTP yields trading 25-35 basis points below yesterday’s highs and EURCHF rebounding back above 1.1400 this morning from yesterday’s lows below 1.1315. But will the EU commission budge as it fears setting a dangerous precedent for populists elsewhere? Let’s see – but governments at the core will eventually have to move to a more expansive stance to keep the populist threat at bay – the difficulty is determining the timeline – but 2019 EU parliament elections are moving onto the radar for next May.

UK Conservative party character-in-chief Boris Johnson stopped short of challenging Prime Minister May of leadership of the party in a speech yesterday, but railed against the Chequers plan and begged the prime minister to revert to her original Brexit goals. May’s latest update to her stance will hit the wires today at 10:30 GMT as she speaks at the conference. A more aggressive stance that is unlikely to mean a deal with the EU can be struck won’t necessarily prove GBP-negative if the sense is that the Tories will never deliver Brexit and we end with an extension of the negotiation period and the unknown of either an eventual election or second referendum.

Elsewhere, US Fed Chairman Powell delivered a speech yesterday in which he saw little risk of aggravated rises in inflation from an overheating labour market, saying that the combination of very low unemployment rates and steady, low inflation points to “extraordinary times”. But given that Powell has previously suggested that it is not inflation, but financial stability risks that are the chief risk to the economy, and given that high yield bond spreads are by some measures the lowest they have been since the global financial crisis, suggesting that financial conditions are as easy as ever, this Fed is likely to continue to provide steady rate hike pressure for now.

Chart: EURCHF

EURCHF is fibrillating in the range below the prior notable pivot around 1.1440. It seems clear that if the EU and Italy can put off the budget showdown for another year and EU core rates can move back toward a normalisation path higher, that EURCHF would look higher, potentially blasting all the way back into the 1.1800-1.2000 range if the 1.1440-1.1500 pivot zone hurdle can be cleared.