It's a bit too soon to hop on the euro relief rally bandwagon

John Hardy

Head of FX Strategy, Saxo Bank Group
John Hardy joined Saxo in 2002 and has been Head of FX Strategy since October 2007. He focuses on delivering strategies and analyses in the currency market as defined by fundamentals, changes in macroeconomic themes, and technical developments.

The euro has lurched into relief rally mode on the news that the Italian populists have abandoned their efforts to form a government after Italian president Mattarella rejected their eurosceptic choice for finance minister. But how this provides any sustainable relief in the situation is entirely unclear. 

For the near term, the appointment of a caretaker government until new elections would cap the immediate prospects of a further credit spread widening, but eventual new elections could actually strengthen the mandate for the populists, who have an even more compelling case for pointing out the threat to Italy’s sovereignty from its use of the euro. 

Alternatively, the situation could devolve into a constitutional crisis via an attempt to impeach the president. In short, the situation is far from over and any relief could prove short-lived and reversed by the next headline.

The other elephant in the room is the decline in US yields since the publishing of the Federal Open Market Committee minutes last week, a development that has altered the playing field across asset classes, as the 2.95-3.05 pivot zone break in the US 10-year benchmark now appears to have reversed. In FX, this development has most immediately impacted the rate-sensitive USDJPY, which has reversed hard from its recent rally highs. Some of the JPY bid last week may have been down to EU existential stress and EM volatility, but US rates are an important driver.

Elsewhere, EM currencies have generally caught a relief bid, with the Turkish lira even trying to right itself this morning, but emerging market assets are not doing well and our measures of risk aversion are not at all supportive at this time as covered in our most recent EM FX Weekly. So, if the reversal in long yields is down to weak risk appetite and weak growth prospects, this is not likely to support risky assets as only a return of “Goldilocks” (sidelined yields as economic growth chugs higher with no inflationary implications) would likely do so.

USDJPY has reversed hard from its recent highs well above 111.00, with the reversal in global yields likely the chief contributor, although EURJPY action late last week may have also been a flow-driver on the euro’s existential distress. If US yields are capped for the cycle, especially at the long end, this may provide a cap for USDJPY as well and drive the pair back into the lower range as long as we remain below the pivotal 110.00-25 area.

Remember that today is the US Memorial Day holiday and markets will be closed there as well as in the UK for the May UK bank holiday. For the week ahead, besides the fully energised situation in Italy and ad hoc headline risks that will likely impact the market all week, we focus on CAD, where the Bank of Canada may err on the side of caution in its guidance, given the recent focus on macro-prudential efforts putting the brakes on the economy and the very steep decline in oil prices (lots of focus on OPEC/Russia news cycle after last week’s indication that they would like to boost production – the next key meeting is not until late June). US-Canada yield spreads have been locked in a very tight range.

 Chart Source: Saxo Bank

The G-10 rundown

USD – the greenback rally faces a test of its own on the recent decline in bond yields that we discuss above. Risk appetite has held up well, which is USD negative as long as rates are lower, but if risk aversion makes a comeback, the USD may perform well, ex USDJPY, due to its superior liquidity.

EUR – a relief rally built on wobbly legs. Even if the situation stabilises and credit spreads fail to widen, the EU is far from a “solution” that addresses the source of Italy’s woes. 

JPY – the yen caught a dramatic bid last week, on a combination of EU existential distress And lower US bond yields in the wake of the FOMC minutes. Looking for further strength as long as US yields are capped and of course if the EU existential risks are reaggravated.

GBP – sterling is looking lower against the euro this morning, but EURGBP developments have been few and far between for more than a month as Brexit is an endless swamp.

CHF – the franc is the most reactive to the waning EU existential distress this morning, but as we indicate above, we’re far from convinced that the Italian situation can be swept under the rug.

AUD – AUD is trying to catch a bid by default on the boost to risk appetite. It’s a light week for Australia event risks, and AUD may trade passively to the dominant themes. AUDUSD key zone is 0.7600-50.

CAD – The Bank of Canada event risk perhaps holding USDCAD back from a significant 1.3000 break in the wake of the steep sell-off in crude oil. Stay tuned.

NZD – the kiwi has a bit more room to consolidate versus the AUD (into 1.0800-50), but watch out for the new Reserve Bank of New Zealand chief Orr out speaking on Wednesday, as his recent dovish broadside at the RBNZ meeting set the NZD sell-off in motion.

SEK – any EU existential relief is SEK supportive, and there is room to the next major support in EURSEK down toward 10.00.

NOK – the krone not enjoying the steep slide in oil prices, as EURNOK has shied farther away from the sub-9.50 breakdown level.

Economic Calendar Highlights (all times GMT)

US Memorial Day Holiday Today – Markets Closed
0730 – Sweden Apr. Retail Sales
0800 – Switzerland Weekly SNB Sight Deposits
2330 – Japan Apr. Jobless Rate



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