Italian storm clouds return

After enjoying a day of sunshine earlier in the week, storm clouds returned to both the Sydney skyline and global financial markets yesterday.

Leading the way lower in the Asian time zone was the Chinese equity markets. The Shanghai Composite, after closing down -2.90%, is now 30% below its 2018 lows and at levels last seen back in 2014. Storm clouds also for U.S. stocks as the S&P500 futures tumbled -1.50% to close at 2775.25 after retesting the 200-day moving average at 2770. As highlighted earlier in the week, noticeably absent from last week’s price action at the lows, is clear signs of seller exhaustion/capitulation as indicated by reversal/loss of momentum candles often sighted at equity market lows. The expectation remains for further weakness in the S&P 500 before the customary end of year rally begins.

However, the focus of today’s article is on the overnight events in Europe, as the EU and the Italian government continue to posture over the details of the draft Italian budget. A series of news articles hit the wires late in the U.S. session including one on Bloomberg which suggested the EU are unhappy with the unprecedented Italian budget deviation and potentially serious non-compliance with EU rules. In response, Italy’s 10-year bond spread to German Bunds widened to its lowest levels since 2013 and the EURUSD fell below 1.1500 as a result. It seems unlikely the Italian budget will be approved by the EU Commission in its current form and the pressure is now on the Italian Cabinet to address the EU’s concerns before the EU meet to discuss the Italian budget early next week.

Also looming on the horizon for the Italian Government is a decision from the ratings agencies (Fitch, Moody’s and S&P) on Italy’s sovereign debt. Moody’s is expected to make an announcement by the end of October, while S&P is due to make an announcement, next week, October 26.

The market is expecting a one-notch rating cut (from BBB), although there is a small chance of a larger cut which could see Italy’s debt fall below investment grade and make Italian Government securities ineligible for many of the largest world bond indexes.

The question then becomes why are the fortunes of the Italian budget and bond markets so important for the EURUSD? One of the main drivers of the EURUSD this year, as can be viewed on the chart below, is movements in the Italian Bond market. Specifically, when the yields on Italian 10-year bonds (BTP’s) have moved higher, they have negatively impacted the EURUSD.

From a technical perspective, the rally in Italian bond yields this week has resulted in the EURUSD soundly rejecting levels above 1.1600 to now be within touching distance of the key 1.1430/20 support (1.1432 the low from earlier this month). Providing the EURUSD can hold above 1.1430/20 another up leg is possible. That said, a break and close below 1.1430/20 caused by another move leg higher in Italian bond yields, should ensure a retest and break of the August 1.1301 low and possible extension towards 1.1150.

Source Tradingview. The figures stated are as of the 17th of October 2018. Past performance is not a reliable indicator of future performance. This report does not contain and is not to be taken as containing any financial product advice or financial product recommendation

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