01 Oct 2018: Euro shows its fragility

Euro shows its fragility

October 1st: Highlights

  • Rome upsets Brussels with broken Budget pledge
  • Sterling remains under Brexit pressure
  • Dollar rallies against weakening Majors

Italy budget likely to break EU rules

Despite a threat to resign by the Economy Minister, the Italian Government voted through a budget that will be at least 2.4% of GDP. The Budget that was placed before the Italian Parliament on Friday was significantly higher that had been proposed by the Economy Minister, Giovanni Tria who had put forward a budget valued at approximately 1.9% of GDP coupled with a significant reduction of Italian Government borrowing over a three-year period.

In the end Sr. Tria caved in under pressure from the coalition partners. The previous administration had agreed with Brussels to work to reduce the fiscal deficit to 0.8% of GDP over the same three-year period.

The sense of triumph emanating from Five Star and the Northern League may be short lived as the new plans are way above what Italy can afford or what the EU will be comfortable with. There is sure to be a response from Brussels and that expectation caused the single currency to tumble on Friday.

Once Parliament has added a few extra considerations to the bill, the budget may be even looser by the time it reaches Brussels next month for final approval. This approval process is one of the conditions that were agreed by the previous administration in order for it to be allowed to borrow to a level which increased borrowing to 130% of GDP. It is one of the group of “nooses” that the new coalition feels are tightening around Rome’s neck.

The euro reached a low of 1.1569 versus the dollar on Friday before recovering to close at 1.1604.

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Sterling under pressure as Conservative conference begins

Whatever the outcome of the Conservative Party Conference which started yesterday, it is almost certain to do no good at all to the prospects of Theresa May or her Chequers Proposals.

The Government’s plans for the future relationship between London and Brussels lay in tatters, yet Mrs May and to a lesser extent her Brexit Minister continue to cling to them like the final hope of a shipwrecked sailor.

Boris Johnson the highest profile Brexiteer again attacked the Chequers Proposals, which led to his resignation as Foreign Secretary, over the weekend, calling them “deranged and preposterous”. Unless a solution is found soon, Johnson may run out of superlatives!

Johnson’s stance has been criticized by senior members of the Conservative Party who have labelled him anything from irrelevant to dangerous

The forex market had what looks like the start of an epiphany on Friday where the realization started to dawn that a hard or no-deal Brexit is becoming a plausible outcome of the negotiations. This saw the pound fall versus the dollar despite no fresh or concrete evidence for pessimism

Both sides admitted last week that an impasse has been reached and they both need to go back to the drawing board.

It is becoming an impossible situation.

Brussels cannot deviate from the rules that have been put in place to deal with just such a situation yet needs to have a trading relationship for the sake of its export base. London needs a deal to ensure that the economy doesn’t collapse into recession and much higher inflation following Brexit but must preserve the integrity of the entire UK.

The pound fell versus the dollar on Friday but not as much as the single currency which meant that the pound rallied versus the euro early in the day.

Apart from Brexit, the pound was hit by poor data for Q2 GDP which showed that the economy grew by just 1.2% and the previous estimate was revised lower. Business investment also fell.

The earlier support for the pound from better than expected retail sales and employment data drained away as it became clearer that unless there is a positive result from Brexit the economy will slow further and the BoE may be forced to reverse its recent interest rate decisions despite higher inflation.

It reached a low of 1.3000 versus the dollar recovering a little to close at 1.3030, while against the euro it rose to 1.1270 although it fell back to close to it its opening level at 1.1228.

Dollar rallies by default

The dollar index rallied to a high of 95.37 on Friday before closing at 95.19. Its rally was due almost entirely to the fall in the euro, although there are still positive drivers that could see it rally further.

The widening interest rate gap between the U.S. and its G7 partners continues to provide support while the ongoing trade spat is leading to a “rush to excellence”, to the detriment of emerging markets.

This week sees the release of the U.S. employment report with the data likely to support the Fed’s recent actions.

The first indications are of a rise of 188k new jobs. This is hardly surprising, as it is also the six-month moving average of the data. It is so unreliable and difficult, if not impossible, to predict that most analysts are hedging their bets and wagering on the trend.

As usual, wage inflation will also be a factor and that is expected to remain strong. After last month’s rise of 2.9% it is expected to hit 3% which totally justifies continuing the Fed’s recent course of action

Multiple interest rate hikes between now and mid 2020 should see the Fed Funds rate top out at 3.5% but there is a lot of advance guidance to be given before we see that level reached.

Have a great day!

About Alan Hill

Alan has been involved in the FX market for more than 25 years and brings a wealth of experience to his content. His knowledge has been gained while trading through some of the most volatile periods of recent history. His commentary relies on an understanding of past events and how they will affect future market performance.”