Italian concerns heating up

The euro is coming under pressure today after news that the Italian finance minister, who is credited with helping to keep Italy out of the sovereign debt crisis even though its debt-to GDP ratio is an enormous 120 per cent, is becoming embroiled in a corruption scandal. Italian politics has been tainted by scandal in recent months, and the last thing it needs now is a political crisis to give investors reason to ditch Italian debt a la Greek, Irish and Portuguese style.

Italian bond yields have spiked higher today and this has knocked the wind out of the single currency after it staged an impressive rally yesterday. Not only was ECB President notably more hawkish than expected, he continued to ram home the idea that interest rates in the currency bloc remained accommodative (try telling that to the Fed or the BOE). The central bank also announced it was bending its rules and allowing Portugal to continue to borrow from the Bank, thus staving off a banking crisis for the smaller Iberian nation.

But today’s price action is concerning and highlights the volatility sovereign concerns are having on the market. The euro has been extremely resilient in the face of the sovereign debt crisis, yet if the single currency is reacting less to its positive yield differential and more to sovereign concerns then this concerning.

While European sovereign concerns rumble on, the main event today is payrolls out of the US. The market is looking for an increase of 105k, a vast improvement on May’s dismal 54k, but far from the 200k jobs the US needs to be creating on a monthly basis to bring down the unemployment rate.

Payrolls traditionally set the trading agenda for the month and last month’s report caused a bout of selling. But after reaching a low last week, the markets have staged a stunning rally and are back to their early June highs. So the risk is that a disappointing payrolls number will cause a sharp reversal.

This month’s report is almost more important than others since the market will use it to test the temperature of the US economy as a whole: was last month’s weak report just a blip or the start of something more sinister?

It’s always difficult to predict how markets react to payrolls. However, a strong number – anything sub 120k in NFP’s and sub 150k in private sector payrolls -0 would likely spark a rally in risk in our opinion. Stocks should rise and bonds should fall, pushing yields up. But the dollar doesn’t know if it’s a growth currency or a safe haven at the moment. We think that a positive figure would be positive for EURUSD – as the Eurozone needs a strong US to boost export growth especially in the periphery, it would also boost the Aussie as it would suggest that demand for commodities will remain supported.

However, the yen may come under pressure along with the pound as interest rate differentials move in favour of the buck. USDJPY has a close positive relationship with US bond yields. 10-year yields have risen strongly in the past week and a high number today could extend that rally and we could see 10-year yields breach 3.2 per cent. If this happens we could see USDJPY head towards 82.00.

The markets will take its cue for the rest of the day from payrolls. It’s also worth watching where some of the major pairs close the week. EURUSD is in a technical downtrend below 1.4380, if we close below 1.4240/50 that would be a bearish signal as we move into next week and the Eurozone stress test results. We have just heard that Italian banks have passed the tests, but the results of Spain’s beleaguered banks are more important for markets.

Political issues in Italy, the US and the UK are also worth keeping an eye on. There was some positive news from the US last night after Democrats and Republicans said that both sides would make concessions to ensure the debt ceiling is raised before the early August deadline. In the UK, although the phone-hacking scandal at the News of the World newspaper in the UK has no macro impact right now, Prime Minister David Cameron is getting more and more drawn into the scandal and its worth watching how this pans out, especially since his former head of communications was a one-time NOTW editor.

Source: Forex.com

08.07.2011