Italy Referendum the calm before the storm

As we approach the European open for markets one thing is strange – why hasn’t the euro fallen off the cliff, and why are futures pointing to a positive open for Italian stock markets after the No result in last weekend’s referendum? Have financial investors’ boosted their immunity to political “shock” events like this one, or did the defeat of Austria’s Far Right party at the weekend suggest that there is still life in the EU project?

After an initial dive in EURUSD, it managed to bounce off 2015 lows, and stabilise above 1.0550, above the lows from two weeks’ ago. While the euro is still the weakest performer in the G10 this morning, the yen, which had initially surged on Italy’s referendum result, has also given back some earlier gains. Euro options markets suggested that investors were not too worried about this weekend’s referendum, so where do European asset prices go now?

Can Italy’s oldest bank survive?

There are still some key risks on the back of the No vote, but we think they will manifest themselves in Europe’s banking sector. If there is any sign of a run on Italy’s banking sector then we could see panic spread to global financial sectors, including London and New York. Monte dei Paschi, Italy’s third largest and its oldest bank, is desperately trying to raise EUR 5bn, and sell EUR 28bn in bad loans. The No result in the referendum has undoubtedly made it harder to attract private sector capital to fill Monte dei Paschi’s gaping capital hole, and bring it back up to a standard where it could pass under the low bar of the ECB’s stress test, which it failed in the summer. The risk is, that investors lose faith that it will be able to do this, which triggers a run on the bank and a full blown financial crisis that starts in the currency bloc, but could emanate around the world.

Sanguine markets suggest a break up of the euro not on the cards

Stock market futures do not suggest that banking turmoil will happen, at least not at the start of the week; 1-month euro risk reversals suggest that volatility in the euro remains fairly muted, so no major event risk is currently priced in. However, sentiment is fragile and we need to see how much patience investors will have with Italy during its process to find another government.

Italian PM Renzi will formally resign today. The President will then be tasked with trying to form a new government. There is still a chance that Renzi could be asked to lead a temporary government, however, his heavy defeat in the referendum throws this into doubt. Any sign that the anti-establishment Five Star Movement is likely to win a future Italian election, could be the canary in the coalmine for the euro and risky asset prices. From a fundamental perspective, even if the reaction to the euro has been muted so far, there are serious headwinds for the single currency and the risk of parity for EURUSD remains.

Has Austria’s election calmed markets?

This wasn’t the only political risk in recent days. Austria’s election saw the Far Right anti-establishment and anti-EU candidate lose last weekend’s election. This has potentially given some hope to the future of the EU, which could be triggering this EURUSD recovery that we have seen extended into Monday.

Key Brexit decision and the pound…

Elsewhere, one eye will also be on the pound today and the reaction to any Supreme Court judgement on whether the Government can trigger Article 50 (and thus Brexit) without a vote on the matter in Parliament.  GBPUSD is back above 1.27 as we wait for the judgement, which is expected at some point today.  If the government loses its appeal, we could see another leg higher in GBPUSD. Like the euro, the options market also does not seem too worried about the outcome of this Supreme Court ruling.