Stocks cheer signs of Italy breakthrough

Summary

A more convincing patina of positive sentiment in Europe with help from Italy.

Spread goes seasonal

With Italy’s stock market out in front, at least some of the lift is attributable to the latest sign of a thaw in relations between Rome and Brussels. The reported agreement between the Commission and Italy’s coalition to settle for a 2.04% deficit, vs. the non-compliant 2.4% Rome initially proposed, adds more impetus to already ongoing benchmark bund-BTP yield spread contraction. The 16.4 basis point spread narrowing at, last look, is the fastest since June. Still, there have been other sessions over the past few months when the rates have coalesced at a similar pace. A lack of detail in the reports and a possible ‘sell-the-news’ reaction could even limit the positive reaction that has bolstered Milan stock markets and pulsated a brighter mood more broadly.

BTP yield set for early 2019 test

That includes the euro where single currency bulls have been handed further impetus to extend the bounce since Friday. A key target remains $1.1428, the last clean spike high before weakening that eventually saw EUR/USD bottom at $1.1266 at the end of last week. As for Italian bonds, the game was up for BTP sellers when its yield trend line established in September caved towards the end of last month. The kick off point of the rise at almost 2.7 basis points now looks like an objective. A gap created by Wednesday’s rapid BTP price bounce could attract opportunist bond selling, interrupting the rate of yield deceleration momentarily. But a revival of anxieties that underpins the yield looks unlikely to be sufficient to halt its fall.  Italian shares may therefore have a smoother road ahead. The euro should also have a moderate tail wind. Still, market structural considerations in early 2019—ECB bond buys coming to an end; higher Italian supply—could pressure BTPs anew in a few weeks. Investors will keep an eye on key yield support.

Fed to stress data-dependence

In the nearer term, the next challenge for markets in Europe and beyond will be the Federal Reserve’s decision this evening that is unlikely to back Fed fund market expectations pointing to only one rate rise in 2019. Avenues for disappointment therefore remain, even if the dot plot of FOMC rate forecasts duly turns lower and the statement turns unmistakeably dovish. Isolated exceptions aside—like November payrolls—U.S. economic data continue to portray a solid economy. Hence a clear signal that tightening has run its course is probably off the cards. And the Fed will probably flag the next “data-dependent” rise sometime in the first half of 2019. The immediate effect of such a reminder from the FOMC would be a reinvigorated dollar and all that that has implied this year, with underpinned Treasury yields that call for another re-think for investors tempted to dip back into the water. Commodity-related currencies like the Aussie and yuan and other troublesome FX markets like the euro and sterling will also probably lose traction apparently gained this week. Equity markets have barely needed such cues in recent weeks to head lower. A broader ‘risk-off’ would be sufficient to confirm the widely anticipated end to 2018 that stock markets already point to.