Italy’s leading anti-establishment parties abandoned efforts to form a coalition government, offering the single currency and peripheral bonds a measure of reprieve on Monday. The talks collapsed after Italian president Sergio Mattarella blocked the M5S-Lega coalition’s euro-skeptical choice for finance minister.
But defusing near-term Italian political risk does not offer a clear path higher for the euro in coming months:
- Italian political risk is delayed rather than resolved. Italy will likely face a polarizing electoral campaign for the next few months. This concern may help explain why the euro failed to hold on to its initial 0.6% gain versus the USD and was flat by mid-day trading in Europe.
- Italy isn’t Europe’s only political problem. Spanish politics are souring further, with snap elections increasingly probable either this year or after the 2019 European, regional and local elections. Spanish 10-year spreads over Bunds today rose to 1.083%, just shy of this year's peaks.
- Eurozone economic data has continued to fall short of expectations. Purchasing managers index readings in Germany and France weakened amid global trade tension and rising input price pressure from higher oil. We have recently trimmed our 2018 Eurozone GDP forecast to 2.2% from 2.5%.
While we believe the euro is undervalued versus the USD based on long-term fundamentals, the drivers behind its recent decline remain in place. Traders still have more USD short positions that could be unwound, while uncertainty about the political and economic outlook in the Eurozone has been growing. Our three and six-month EURUSD forecasts stand at 1.20 and 1.25, respectively.
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