EUR/USD: 'A Perfect Storm': Is It On The Verge Of Collapse?

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The Trump win has triggered a ‘perfect storm’ for EUR/USD. Hopes for fiscal stimulus and earnings repatriation in the US have lifted USD while political risks ahead of the Italian referendum and the general elections in France, the Netherlands and Germany are weighing on EUR.

Predicting the outcome of political events this year has proven impossible and this can explain the very defensive market stance towards EUR at present. Indeed, according to our simulation analysis, confirmation of market fears about escalating centrifugal forces in the Eurozone could have a significant negative impact on EUR/USD.

We do not think that the Italian referendum will significantly change Italy’s political landscape or that Marine Le Pen can win the French presidential election without the support of a mainstream party. We thus doubt that EUR/USD is on the verge of a collapse. 

---The Italian referendum On 4 December, the Italian population will get a chance to vote on the reform in the Senate. The reform has been proposed by the government in an effort to improve the governance and speed up the reform process in the economy. Ahead of the referendum, opinion polls are suggesting that the population is increasingly likely to reject the proposal. The outcome could trigger more political uncertainty especially if PM Renzi stays true to his pledge to resign in the event of a ‘No’ vote.

EUR could suffer initially on the back of a ‘No’ vote. Importantly, the weakness may not be sustained, however. Indeed, CASA economists expect that, even if PM Renzi were to step down after the referendum, he will likely get a chance a chance to form a second government and thus preserve the status quo until the general elections in April 2018. The market attention will shift to the Italian constitutional court, which will have to rule on the proposed legislative reforms once the ‘advisory’ referendum is out of the way. A ‘No’ vote could slow down but need not derail the reform process in Italy. A ‘Yes’ vote could help EUR recover in tandem with tightening peripheral spreads.

In Figure 3 we look at the various outcomes and the probability that the CASA economists have attached to each outcome. Our results suggest that EUR/USD could be quite volatile and drop 1.7% if Italy heads to new elections after the referendum. Importantly, a ‘Yes’ vote could trigger a rebound of more than 2%... In particular, we estimate that EUR/USD should consolidate after the referendum on 4 December.


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