Head of FX Strategy
The headlines from the Italian election suggest that the inconclusive results are no major surprise and will likely lead to a long period of coalition negotiations and an extension of the general status quo of a dysfunctional Italian political scene. But I believe that the result is rather more dramatic than the immediate spin suggests. The votes garnered by the populist parties were beyond the extreme end of recent polling projections, as the Five Star Movement appears to have reaped a larger vote than was generally expected (over 30% vs. 27-28% expected), and perhaps most important, on the political right, the anti-immigration and Eurosceptic Northern League achieved a far stronger result (approximately 18%) than Silvio Berlusconi’s more centrist Forza Italy.
Sure, this may bog down for a long time before we see some form of government take shape, and as many point out, there is no actual time requirement for the formation of a new government – could the caretaker Paolo Gentiloni stay in place for the duration? It is inconceivable that that majority in the two houses of Italian parliament would ever approve a right-wing minority coalition led by the Northern League firebrand Matteo Salvini. So, while the political situation in Italy may be a back-burner issue of an EU existential threat, the long-term heat has been turned up dramatically in the wake of this election result. Keep in mind that this is an election outcome that arrives when Italy is doing as well as it ever has since the global financial crisis – imagine if this election had arrived during a raging recession.
Clearly, the EU has its work cut out for it, and the survival of the Germany (not-so-) grand coalition after the SPD vote this weekend is the first major step towards eventual attempts to reassemble the European Union project in a way that it can survive the inevitable next recession. Can the center hold? It will be a very long time before we know, and without immediate pressure on sovereign spreads, etc., as was the case during the 2010-12 EU sovereign debt crisis, the sense of urgency may be lacking. Especially now that major election risks are no longer present. In short, this is a very long term issue and the market doesn’t possess the requisite attention span, so immediate worries may fade fairly quickly.
This week, the general status of risk appetite will quickly become the central issue if we close much lower than Friday’s lows and markets remain volatile. Otherwise, it is a big week for central banks, particularly the Bank of Canada meeting on Wednesday, which is the main event for the loonie this week as we get a sense of governor Poloz and company’s assessment of the risks to the Canadian economy and to its rate hike intentions from US protectionism. While CAD has been quick to weaken, the actual rate outlook has hardly shifted in recent weeks and that could change if the BoC strikes a new, more cautious tone.
Elsewhere, we expect Draghi to err on the side of dovishness, though this is likely priced in, and the Bank of Japan will take pains to point out that any discussion of normalization, a topic it aired last week is highly conditional on inflation rising sufficiently. This won’t matter much for the yen, which has been driven lately by repositioning after excessive complacency and weak risk appetite.