Italy fears subside as focus shifts to the ECB

Italy’s banking stocks surged on Tuesday; the Italian banking index jumped nearly 9%, as the markets took the view that no news is good news regarding Monte dei Paschi’s private sector recapitalisation. Even the prospect of a nationalisation, potentially as early as this weekend, isn’t spooking the markets as it may avoid retail bondholders having to take any losses.

Have Europe’s authorities figured out how to manage a crisis?

The calm market reaction to Italy’s No vote in last weekend’s referendum should ease the pressure on the ECB, who meets on Thursday, although pretty much all of the market expects the Bank to extend its EUR 80bn per month bond buying purchase for another six months, until September 2017. We think it is likely that the ECB will deliver on the markets’ expectations, and extend its QE programme, if not then we could see the rally in Italian banking stocks, and European equities more generally, cut short, and a bounce in the euro.

What next for the euro?

An extension to QE is likely to cut short the recent rally in the euro, but downside could be limited. EURUSD started to pull back on Tuesday, and the decline has continued early on Wednesday. However, we think that the decline could be fairly shallow, at least in the short-term, with 1.06 holding as decent support. The German – US 10-year bond spread is nearing its lowest ever level, which comes in close to -2.3%, it is currently at -2%, thus, unless we get a surprise shock from the ECB, such as an increase in the size of its monthly purchases, then the German – US yield spread may not extend much further to the downside, and this could limit how low the euro goes from here.

Will the Fed live up to the markets’ expectations?

While we still think that the dollar could bounce further, especially in 2017, EURUSD’s short-term direction will ultimately depend on what the Fed has to say about the future direction of US interest rates at its meeting next week. A rate hike has been 100% priced in by the market for some time, more interesting will be whether or not the market is correct to have started pricing in (to the tune of 20%) the prospect of rates at 1.5% at the end of next year. If the Fed believes that President elect Trump’s fiscal largesse warrants a faster pace of rate increases than is currently being priced in, then the market will rush to price in higher yields, which will boost the dollar and weigh on currencies like the euro.

Italy risks still abound

Apart from UK manufacturing data, the markets’ focus will likely be on further details about Italian banks’ recapitalisation prospects. We could also see another upward move in stocks after the Dow, which has outperformed the more tech heavy S&P 500, hit another record high on Tuesday.

Brexit fears ease, but the pound doesn’t care

GBP could also be in focus after the government said that it would provide its plans on Brexit before it triggers Article 50. This failed to boost the pound on Wednesday morning, and GBPUSD continues to slip back below 1.27. We think that this is a technical move, after GBPUSD hit 100-day sma resistance at 1,2790.  Key support lies at 1.2570 – the low from Dec 2^nd.