BNY Mellon: The Aerial View: Italian Markets Heat Up

Oct 9, 2018

By Simon Derrick, Chief Currency Strategist, BNY Mellon

The threat of a showdown of sorts between Rome and EU authorities has been in the air since the start of June, when the new Italian government won its first confidence vote in the Senate.

The reasons why a showdown might have seemed a politically attractive idea are relatively easy to see, given that the combative stance taken by the League on a number of “hot-button” issues has seen its popularity rise with the Italian public, increasing the incentive for the party to seek an early election.

With M5S and the League running neck and neck in the polls the incentive had therefore been for both to take a robust approach to framing the 2019 budget proposal.

This is exactly what happened with the government announcing just under two weeks ago that it will aim for a budget deficit for 2019 at 2.4% of GDP.

The response for the European Commission was as might be expected given the statements that had been made previously as was the equally robust response from the Deputy Prime Minister. 

With the focus now centering on what happens on October 15 - the deadline for Italy to submit its draft budget to the Commission to see if it is in line with EU rules - a familiar pattern appears to be emerging in Italian markets.

With little to argue in favor of support coming from the ECB in light of current levels of stress in the Italian markets, the questions now are how far the Bund/BTP yield gaps can blow out and how this could translate back into the FX market.

It might therefore be worth recalling that by this point in 2011 the spread had already blown out to around 400 bps before widening further in November to beyond 500 bps.

From the perspective of the foreign exchange markets this should bring a renewed focus onto the EUR - although it should be noted that it has increasingly been the USD rather than the CHF that has been acting as the default safe haven from Italian concerns this year.

As just one measure of how important Italian markets have become in driving EUR/USD this year it’s worth noting there has been close to an 86% inverse correlation between the performance of the currency pair and the 10-year Bund/BTP spread over the past six months.

It’s also worth observing that there hasn’t automatically been a connection between flare-ups in European sovereign markets over the past decade and sustained heightened volatility in EUR/USD.

However, it’s arguable that the reason why volatility didn’t emerge during the period of the eurozone crisis is that this coincided with the US introducing multiple programs of QE.

Even then, 21-day realized volatility typically came in well north of 9%, peaking out a little above 13% back in late 2011.