What Caused EUR’s Reaction To The Italian Referendum?

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 EUR Moves Remain Tricky To Pin Down

The Euro’s response to the Italian referendum has once again highlighted the problematic nature of how EUR responds to various risk-off events. EURUSD reversed the initially sharp sell-off in response to the Italian “No” vote to close the day near three-week highs. The move was a near perfect mirror of the price action that occurred in response to the November 9th US elections move where EURUSD rallied initially only to reverse and sell off sharply. Indeed, given the way that EUR has responded to various political events, it seems that trying to gauge EUR direction is as difficult as trying to gauge the outcomes of the various political events themselves.

In terms of trying to understand the Euro’s response to the Italian referendum, there are three key factors we can consider.

  • Markets were already anticipating a “No” vote and, based on the high levels of implied probability priced in ahead of the event, had already purchased a significant level of protection. This would, therefore, have made it attractive to buy EUR on the initial sell-off to pay for option decay bills. This would have been especially true once it became clear that there was not going to be any immediate implosion in the Italian banking sector which had been one of the key concerns aligned to a “No” vote.
  • Some players have judged Renzi’s ability to win 40% of the vote as indicative of a core of support that could be useful and cohesive down the line in terms of progressing Italy’s reform process. This is viewed in contrast to the 60% who voted “No” which are seen as a loose band of ultimately disparate forces.
  • The December ECB meeting is seen as a significant EUR risk event with a growing view among some players that the ECB will signal the tapering of its bond purchases in 2017.

Market Struggling For Directional View

Of importance to note this week is the fact that whilst implied volatility is high, the market is not convinced of which direction and the likely move will follow. Indeed, the market is pricing a high probability of a sharp EUR move this week but has no clear view on which direction the move will occur.

The most likely reason for this is that the fact that whilst the market is expecting that the ECB will do something significant this week, it isn’t sure how the announcement will pan out. Many are expecting that the ECB will deliver new easing measures this week, however, many are also expecting that the bank will also point to the possibility of tapering in 2017.

The path of the Euro in response to a mixed signal such as this is difficult to gauge and much of the reaction will likely rest on how Draghi explains the decision-making process.  Indeed, if Draghi fails to properly explain any move toward tapering, this would create the risk of a European “taper tantrum” which could fuel a surge higher in EUR.

Trading Scenarios

In terms of possible scenarios, since the US elections EUR has lagged USD in terms of rate differentials. Longer-term inflation expectations have moved up enough to provide support for the currency, especially in the context of improved EuroZone macro data.  Indeed, looking at EURJPY is clear that one of the key reasons why the cross has traded so well is because of the widening of long term inflation expectations and rates in favor of Europe over Japan.

If the ECB is seen tapering enough to drive EURUSD to move back above its October lows, then this will push the pair back into its pre- US election range. A sustained move here would likely require a significant tightening of longer term US-EuroZone rate differentials to be justified. Given the complicated outlook for EuroZone inflation, it would seem that a move up into the 1.09-1.12 range would present a good opportunity for a longer term sell though continued improvement in EuroZone data is the biggest risk to this view.

EURUSDDaily

Looking at the technical landscape for EURUSD the retest of the broken October lows around 1.0850 is clearly a pivotal point alongside the retest of broken trend line support in the area also.

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