Italian Elections Pass Without Volatility, So What is Driving EURUSD?

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Italian Elections Fail to Produce a Majority

The Italian elections over the weekend failed to provide any major catalyst for a directional move in the Euro despite a couple of key surprises. The two anti-establishment parties performed much better than was expected judged by the latest polling results heading into the elections. However, no party was able to secure a majority and so uncertainty remains high as coalition negotiations begin, which run the risk of requiring another election.

Despite the elections results however, the FX reaction has been very muted suggesting that the Euro is not particularly sensitive to Italian political developments. So what is driving the EURUSD? While political uncertainty is likely to see some weakening in demand for Italian assets, the currency pass through is likely to remain diluted. The reasons for this appear to be that firstly, the EUR is much less sensitive to peripheral spreads than previously, secondly, there is a much lower level of outstanding Italian bonds held by non-euro area investors. Thirdly, the EUR is far more sensitive to rate spreads and the shifting policy outlook of the ECB.

EUR Hedging Less Than During the French Elections

Heading into the French elections we saw a strong rise in the amount of EUR hedge selling taking place to offset the risk of holding French bonds. However, as there is clearly a much smaller amount being held in Italian bonds, there is not as strong a need to hedge these positions with short positions in EUR. Furthermore, non-euro area investors are able to adjust their exposure within the euro area away from Italian bonds without disrupting the FX market.

EUR Sensitivity to Risk Sentiment

Another reason why the Italian elections are having a muted impact is because EUR is currently much more sensitive to rate spreads given the anticipation that the ECB is on a path to raising rates. Furthermore, EUR has recently started to show a much stronger correlation with risk sentiment, rising when risk sentiment is positive and falling back when risk sentiment deteriorates. Given the high level of foreign investment into euro area equities since mid-2017, EUR tends to now perform better during periods of buoyant risk appetite due to rising equity inflows.

Given this dynamic, unless Italian political developments begin to visibly impact risk sentiment, EUR is unlikely to experience any impact by the elections. While uncertainty around the elections and forthcoming coalition negotiations could weaken risk appetite for Italian assets, it is unlikely to have a broader impact on the euro area. The failure of the anti-establishment parties to secure a majority means that the risk of Italy leaving the eurozone remains very low, which is the only conceivable way that risk appetite could be affected by the elections.

Positioning

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Indeed, the latest COT positioning shows that investors are continuing to grow their long EUR exposure heading into the ECB meeting this week which is expected to confirm the ECB’s hawkish shift. While the ECB is not expected to adjust policy at this meeting, the market is fully prepared for a stronger signal that the bank will continue to dismantle QE over the year.

Technical Perspective

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For now EURUSD remains trapped below the year to date high around 1.2542, within the bullish channel running from Q3 2017 lows. The current consolidation is presenting as a bull flag within the channel, which suggests the potential for a topside break, targeting fresh highs above the current 2018 high water mark. To the downside, key support comes in around 1.2098, where we have the broken mid-2017 high and the rising channel support also.

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