Currency Vigilantes Ready to Strike Again as Italian Vote Looms

  • Traders see euro, not bonds, as best way to play referendum
  • Politics is the ‘new economics’ for currency markets: HSBC

Prodi: Italy's Strength Not Dependent on Referendum

Italy’s constitutional referendum is giving the newly empowered currency vigilantes their latest chance to pounce.

Investors see the euro, not Italian bonds, as the best way to express concern that Prime Minister Matteo Renzi’s reforms will become the latest victim of a rising populist mood. While both assets have fallen in the run-up to the Dec. 4 vote, traders are speculating that the European Central Bank may backstop bonds in the event of a “no” result -- supporting debt markets while further undermining the single currency.

Making the hedge more attractive is the fact that the euro’s decline is seen enduring even after a “yes” vote as Donald Trump’s election continues to boost the U.S. dollar.

While so-called bond vigilantes used to prowl the market dispensing fiscal discipline by forcing up borrowing in countries they saw as erring from the right path, in Europe at least, central-bank easing has nullified their impact. Currency traders have picked up the mantle. Their impact was seen in the aftermath of the U.K.’s vote to leave the European Union. The pound bore the brunt of investors’ displeasure, while bonds jumped amid expectations
of more quantitative easing and rate cuts.

Selling the euro before Italy’s vote “makes a lot of sense given the potential for more expansionary fiscal and tighter monetary policy in the U.S., coupled with the increased focus on political risk and the increased likelihood of more policy from the ECB,” said James Athey, a money manager in London at Aberdeen Asset Management Plc, which oversees more than $400 billion.

The company is planning to head into the vote with no wagers on European bonds, but positioned for a decline in the euro.

‘Uniquely Placed’

“For FX, politics is the new economics,” HSBC Holdings Plc analysts including David Bloom wrote in a note last week. “QE has constrained the bond market, distorted equity prices and narrowed yield differentials. This means FX is uniquely placed to reflect political developments.”

Trump’s election has boosted speculation that Italians will reject the reforms on which Renzi has staked his political future. Deutsche Bank AG economists say there’s a 60 percent chance the vote will fail, while political risk-advisory firm Eurasia Group changed its call this month, and now assigns a 55 percent probability to a “no” vote.

The euro has fallen 3.7 percent against the dollar since Trump’s victory on Nov. 8 began to fuel expectations of diverging economic paths between the euro zone and the U.S. Italian bonds have lost 2.3 percent, according to the Bloomberg Italy Sovereign Bond Index.

HSBC lowered its year-end euro forecast to $1.05, from $1.10 a week ago. The shared currency just posted its longest losing streak since its 1999 debut, and tumbled through a 2016 low of $1.06 on Friday, before rebounding today. Italy’s benchmark 10-year bond yield, which rose above 2 percent this month for the first time since mid-2015, was at 2.07 percent.

Political Risks

“Markets are anticipating two risks at the moment: reflation and populism in Europe,” said Marc Chandler, head of currency strategy at Brown Brothers Harriman & Co. in New York. “If one thinks that the Italian referendum is going to be lost, and it’s not priced in, selling the euro -- which is also being weighed down by other factors -- seems the path of least resistance compared with a rate position.”

Anticipated euro-dollar price swings for the period of the Italian vote surged. Two-week implied volatility climbed to 12.5 percent, approaching the highest since the aftermath of the Brexit vote in June.

If European risks rise, the euro will take the hit, said Aurelija Augulyte, a macro strategist at Nordea AG, who’s advising clients to sell the currency against the pound before the vote. “The pound is still very cheap, and will look much better in light of any unrest in the European political landscape,” she said. “It’s an intra-Europe, relative-value bet.”

Disorderly Move?

While a weaker currency can have a positive effect on trade, a larger, disorderly move of the type the pound saw following the Brexit vote can lead to faster inflation and signal a loss of confidence among investors.

The ECB’s next monetary policy decision in December, just four days after Italy’s referendum, may see the ECB announce an expansion of its QE program. That would amplify the currency-to-bond divergence even further by weakening the euro while supporting peripheral bonds.

“A case could be made of re-entering a long-Italy position eventually, looking for an entry point around the ECB meeting,” said Frederik Ducrozet, senior economist at Pictet Wealth Management in Geneva. While a “no” vote is likely, he said this wouldn’t necessarily turn outright negative for Italian bonds, given that snap elections could still be avoided and ECB stimulus remains supportive.

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