Image © Adobe Images

- Analyst sees potential crisis brewing over Italian debt

- E.U. set Italy ultimatum over budget plans

- Political flare-up could ease GBP/EUR exchange rate higher

With Brexit risks sidelined now that the European Council summit has passed and Prime Minister May retreating to have a good think about how she plays her final set-piece in negotiations, political scrutiny might lift off the Pound's shoulders near-term.

For the Pound-to-Euro exchange rate this comes just as political anxieties swivel onto the Euro side of the equation as we are told by a number of analysts European political risks are fast rising to the top of the Euro's agenda once more.

Focus returns to Italy after E.U. leaders took aim at the country’s budget plans at yesterday's European Council summit.

The E.U. commission has meanwhile responded to Italy's budget plans, giving the government until Monday to explain its “obvious significant deviation” from the E.U.’s rules. The budget set by Italy's coalition government currently breaches the E.U.'s Stability and Growth Pact which requires Eurozone states to respect limits for budget deficits and public debt of 3% and 60% of GDP, respectively.

In a step that could prepare the ground for an unprecedented rejection of a member state’s fiscal plan, the EC last night sent a letter to Italy saying the country’s 2019 budget plans are unprecendented by Eurozone standards.

The European Commission noted against the backdrop of a debt-to-GDP ratio of c.130%, Italy’s fiscal plan would not respect the debt-reduction rule agreed among Member States, which requires a steady reduction of public debt toward the 60%-of-GDP threshold.

"The general tone of the letter sent by the EC sounds tougher than what we had anticipated," says Fabio Fois with Barclays, who believes Brussels will initiate steps to try and bring Italy in line with European rules sooner rather than later.

Concerns over the growing confrontation between the E.U. and Italy is being felt by markets.

"It could be a matter of time before the euro falls through the bottom of its range after the EU signaled a thumbs down to Rome’s budget for the coming year," says Joe Manimbo, a foreign exchange strategist with Western Union.

Italian bond spreads over Germany continue to widen alarmingly.

"Coupled with growing doubts about whether the ECB will actually meet its inflation target any time soon, the growing crisis over Italy – the EU’s third-largest economy - could start to weigh on the Euro," says Marshall Gittler at ACLS Global.

Analyst, Ulrich Leuchtmann at Commerzbank warns Italy's debt dynamics are heading in the wrong direction, and he smells a potential crisis brewing as a result.

"Not another euro zone crisis please. I am beginning to feel too old for sleepless nights during which I wait for the end of Euro Group emergency meetings - while staring at an empty EbS screen, too old to work through thick emergency plans in cooperation with our Macro and IR team in a panic (“10 page each!”) etc. But there is no way around it," says Leuchtmann.

Leuchtmann notes "the combination of the tax-cutting right-wing populists and happy-to-spend left-wing populists in Rome has provided Italian bonds with a momentum that very much reminds of 2011."

Leuchtmann says if yields (10-year BTPs back at approx. 3.7% after all) are back at a level that makes the sustainability of the debt levels look significantly worse then there is no stopping things.

The Pound-to-Euro exchange rate is currently quoted at 1.1387 as it consolidates, but we hear from technical analysts at Lloyds Bank that there is a potential for the August-October rally to extend further.

A potential catalyst to any move higher could well come from the Euro side of the equation, particularly as the impact of Brexit on Sterling will likely be muted for a couple of weeks while both sides work away at negotiations.

"It is too early to raise concerns the U.K. will crash out of the EU next year," says Richard Falkenhäll, Senior FX Strategist at SEB having observed the relatively sanguine reaction by Sterling to this week's news of Brexit negotiation stalemate.

Any impulse lower by the Euro could allow for a break above 1.1461 which is needed to allow a test of "the more important" medium-term resistance in the 1.1520-1.16 region.

Advertisement

Lock in Sterling's current levels ahead of potential declines: Get up to 5% more foreign exchange for international payments by using a specialist provider to get closer to the real market rate and avoid the gaping spreads charged by your bank when providing currency. Learn more here