Strategists: Euro Could Soon See Politics Return As A Headwind To Further Gains

A dominant driver of Euro price action until recently, political risk could be staging its own comeback in the Eurozone.

The Euro could see political headwinds return as a factor in price action in the New Year, according to strategists, as political events now fill the calendar while monetary policy could soon take a back seat once the ECB’s tapering plan becomes known.

The dominant driver of Euro price action until recently, political risk faded from the agenda with the passing of French and Dutch elections earlier in 2017, both of which yielded pro-European Union governments.

However, Catalonia’s forthcoming referendum on independence from Spain, scheduled for October 1st, threatens to push politics to the fore again, while the New Year brings with it the potential for upset stemming from the latest Italian elections.

“Beyond the ECB, market focus should shift to politics. This is likely to prompt an unwind of EUR longs which should subsequently cause a reversion back to our target,” says Meera Chandan, an FX strategist at JPMorgan. “On the radar are Italian elections as well as the evolving situation in Spain regarding an independence referendum in Catalonia.”

The Catalan National Day, on Monday, September 11, is widely expected to yield protests accompanied by loud demands across the region for independence from Spain.

“The exact form that next month’s planned referendum vote will take is unclear following the recent decision of the Spanish constitutional court that the referendum was unconstitutional,” says Cathal Kennedy, a European economist at RBC Capital Markets.

Last week Spain’s constitutional court suspended a piece of legislation made in the Catalan parliament authorising a referendum on secession from Spain, calling it unconstitutional. Strategists at JPMorgan and elsewhere see the threat of independence being remote but nonetheless, flag the vote as a risk to markets.

“Thus far, politics have not been driving markets either in currencies or rates, but is likely a more meaningful driver into year-end,” says Chandan.

Beyond the Catalan vote in October, Italy’s 2018 election will likely take centre stage, bringing with it the risk of an anti-Euro or anti-immigration government that could further complicate EU policy making.

Opinion polls frequently place the Five Star Movement, a party that wants to call a referendum on Italy’s continued use of the Euro, neck and neck with the left of centre government of Matteo Renzi.

However, the resurgence of former Italian premier Silvio Berlusconi, and a possible coalition of his Forza Italia party with the anti-immigration Northern League party, ate into Five Star’s share of the vote at a series of June regional elections - muddying the waters ahead of 2018’s national vote.

“Our base case for Italy is that the elections deliver a cumbersome coalition but nonetheless one where an EMU referendum remains a very low-odds event,” says Chandan at JPMorgan.

The Euro-to-Pound exchange rate was down by 0.25% during the morning session Monday, quoted at 0.9088, although it is up by 6.8% for the year to date. The Euro-to-Dollar pair was also down Monday, quoted at 1.2012, but still up by more than 14% for the year to date.

“Nonetheless, this could be a catalyst for a weaker euro since monetary policy will no longer be in play in the months immediately following the taper announcement and thus prompt a risk reduction from investors who have gotten long EUR in anticipation of an ECB policy shift,” Chandan says.

The Euro has surged broadly against all of its global rivals during recent quarters as receding political risks combined with a firming economic recovery in many core Eurozone countries, leading markets to bet on a looming end to the European Central Bank’s extraordinary monetary policies.

For its part, ECB policy makers were seen setting the stage for an eagerly anticipated tapering of Eurozone quantitative easing last week, at the bank’s September meeting.

“We continue to see tapering starting in January and running through June but we have pushed off the first hike in the deposit rate until early 2019 owing to more cautious language from Draghi,” says JPMorgan economist Bruce Kasman, who sees the initial announcement of a taper coming in October.