Weekly Comment, Deja-vu

 Overview 

Fears and concerns surrounding the political turmoil in Italy and renewed trade uncertainty between the US and China pushed equities lower and put bond markets under severe strain on Tuesday.

Italy is headed for new elections, and investors worry the about tail risks for the EU.

US and UK markets returned after their long weekends on Tuesday to the news that Italy’s political crisis had deepened while they were away. To recap, after President Sergio Mattarella’s rejection of its choice of Paolo Savona as finance minister saw The League walk away from efforts to form a government, Mattarella appointed Carlo Cottarelli, a former IMF official, as interim Prime Minister. For now the risk is still valid and fluid for markets.

This has resulted in contagion risk fears in the EU as Spanish PM Mariano Rajoy will face a no-confidence vote in parliament on Friday. This could lead to the removal of his minority centre-right government increasing the risk of replacement by the Socialist Party

In the UK EU officials warned that the current UK position in Brexit negotiations mean no chance of progress. Three days of talks in Brussels have reportedly broken down.

In the US, it was announced on Tuesday that it would in fact implement tariffs on $50bn of Chinese goods as well as place limits on Chinese investment in the US.

FX responded to the risk off mood with USD, JPY and CHF acting as safe havens. The DXY traded just shy of 95.00 before paring gains. Although brutal the moves in FX were tame in comparison to bonds with the EUR losing over 1% on the day, yet, more than 7% since April.

CFTC data affirms only mild paring of EUR longs last week, however a large contingent remains embedded in the market leaving the market vulnerable to a squeeze higher.

Rates 

US Treasury prices have been driven by the move in European bonds, namely periphery markets. Short and flattening positions were strongly pushed lower in a flight to quality move, widening spreads to levels not seen in 5 years. The Italian political crisis looks set to devolve into fresh elections that could end up being a de facto EUR referendum there, but extreme nature of BTP moves looks like huge leveraged positions getting stopped out. The 10y yield spread has still managed to make it above 290bp now, up from a spread of 122bp at the start of the month and marking a fresh 2013 high. Political event risk in Italy will still be prominent as well as early elections look probable by Jul/Aug maintaining the risk off mood. However, the market’s fear of Italy leaving the Euro looks over cooked.

Treasuries extended their rally after the weekend pushing yields down to 2.75% technical support. 10 year Bund yield traded to a low of 0.19%. Pressure increased on outright shorts and flatteners as real money buying increased in a very one-sided market. The 10yr yield notably broke support at 2.92% , (gap still unclosed to 2.905%) that had support the markets during April.

The Italy/Germany 10y yield spread meanwhile broke firmly above 250bp on Tuesday, trading to highs not seen since Oct 2013 when the EZ was exiting from the last crisis. This was driven by a classic risk off move, favouring Bunds and punishing BTPs.

 Spain vs Italy 

Seeing Spanish and Italian spreads trade to levels not seen since the exit of the last European crisis brought with it painful memories. However, simultaneous bouts of political instability don’t mean the two countries face similar problems. Italy and its issue to form a (euro friendly) government, and Spain’s Rajoy potentially suffering another vote of no confidence in the Spanish parliament.  

Italy has a euroskeptic majority in parliament that’s looking to strengthen its hand in a repeat election after President Sergio Mattarella blocked it from taking power. This issue is still on going.  

Spain’s political crisis comes with the economy success along with 3% growth and the budget deficit set to meet the EU’s limit for the first time in a decade.

Even with Prime Minister Mariano Rajoy’s party in freefall, the three main pro-market parties still have the backing of 65% of voters while the anti-establishment group Podemos has less than 20%. according to a poll published Monday by news website El Espanol.

Spain/ Germany 10 yr yield spreads have moved in sympathy with Italy, however we view this as unwarranted.

We look for a reversal of this move entering the market at 131/132 bps, looking for a correction back to 100bps.

FX Positioning (CFTC) 

Speculative positons for the USD continue to close short positions and switching into fresh longs.

Last week saw a further USD 2bn decline in bearish dollar holdings.

The aggregate net short position of the market on the USD now stands at USD 8.50bn, the lowest level in 5 months. Short EURUSD positons being the majority. Excluding the EUR, the net position on the USD is bullish to an amount of USD 7.8bn.

In summary, the macro backdrop is supporting the USD bull argument with focus on whether the Fed will normalise policy faster than anticipated. Nevertheless the EUR still retains a large bullish position despite the robust clear out.

EUR 

EURUSD, up to very recently has weakened mainly due to USD strength. This however has changed rapidly from last week as market attention turned to movements in the BTP market. Italian spreads have moved more than 140bps wider, (10-year BTP’s against Bunds). That coupled with a possible vote of no-confidence in Spain has seen EURUSD trade lower to 1.1510/20, in what to me seems like capitulation move.

Over the weekend, the Italian President caused a quick end to the formation of a Conte government with his refusal to appoint Paolo Savona as minister causing EURUSD to appreciate. This uptick was quickly reversed later on the concerns of new elections in Italy. This limbo is not favourable to the Euro and will remain a valid risk well into the summer. Expect ping-pong market moves from headline risk.

It’s still not clear how far the populists would take their challenge to the EU. Both parties toned down their previous opposition to the euro during campaigning for the March election, but their refusal to consider an alternative to euroskeptic economist Paolo Savona as finance minister fuelled concern among investors that they may still be plotting to leave the single currency.

As a result, safe havens such as US government bonds and the Japanese yen will remain in demand until the election outcome.

The FX market is clearly confident that the ECB will manage to once again overcome the crisis and will at least prevent spill-overs to other euro zone countries. However, the damage done by the 7% depreciation of the Euro will not be as quickly reversed.

Technically, EURUSD has traded lower by more than 7% from its April highs to finally come to a stop on the 50% Fibonacci support level of 1.1550/1.1500, measured by the 2017/2018 move. The risk of an extension lower still persists and we do not rule out a further but less committed push lower to 1.1400 trendline support. This area markets the 200 mma where final profit taking would be expected.

EURUSD will remain bearish over the short term while prices stay below 1.1710/20, where the downmove accelerated, and 1.1830 over the medium term. Above this area upside moves will meet resistance at 1.2000, the May high and 200 mda. RSI and momentum indicators suggest exhaustive selling at current levels.

At current levels 1.1575/80, we are more confident in building medium term long Euro positions using 1.1500 as a stop for an eventual move back towards 1.2000 during the summer.

 Economic Data/Releases 

This week brings some important economic data. In the US, PCE data and NFP are the headline data. Inflation numbers in Europe will also be closely watched especially with the return of the Italian (and Spanish) political crisis.  

Friday sees the US employment report where the current market consensus for nonfarm payrolls is 190k. As a reminder that follows a softer than expected 164k in April and also a below market 135k reading in March. The average miss in the last two months has been 40k. The last three May nonfarm payrolls readings have seen a large divergence from the consensus. The average hourly earnings data is again a main focus. The consensus expects a +0.3% MoM reading and a +2.7% YoY reading (from +2.6% in April). The unemployment rate is also expected to hold at 3.9% along with average weekly hours at 34.5hrs.

Thursday brings the April PCE report in the US. The consensus if for a +0.1% mom reading which would lower the YoY rate to +1.8%. Remember that core CPI in April. 

Inflation data in Europe is due for release on Thursday. Following a seasonally impacted, but albeit softer than expected +0.7% YoY reading in April, economists’ consensus expect the core print to rise back towards +1.0% in May, before rising to +1.3% to +1.4% by Q4 this year. 

Due to the current hot topic of Italy and contagion fears, a close attention to headlines is warranted. This is core market-moving news at the moment.  

There is some ECB speakers expected this week, where we can expect some attention to be drawn to the current issue.

 CAD 

The Bank of Canada meet this week to vote on monetary policy. At the last meeting in April, the BoC signalled an increased willingness to raise the key interest rate, however remaining cautious.

Ongoing NAFTA negotiations still pose a risk to Canada's export sector. Global Trade War issues and renewed turmoil in Euro markets will all contribute to the BoC staying pat on rates on Wednesday.

The publication of the new projections in July would provide a good opportunity to raise the key interest rate. Market consensus is for unchanged rates today, therefore we expect little in movement in FX space.

The BoC raised interest rates by 25 bps in January 2018, to 1.25%. Inflation is in the middle of its target of 1-3%, and core inflation has also reached the 2% once again.

At the April meeting, the BoC noted that inflation and wage growth were moving in the right direction, aided by the historically low unemployment rate. Domestic growth has also been increasingly positive, with the BoC expecting it to grow over the medium term.  

Oil Prices have contributed to a stronger Cad, albeit this move is currently being unwound with weakening energy prices following OPEC announcements last week. Broadly speaking USDCAD has consolidated for most of May, but now is squeezing higher supported by the stronger USD.

The publication of the new projections in July would provide a good opportunity to raise the key interest rate. As most market participants expect unchanged rates today, the CAD won’t suffer much in case the BoC stands pat. A more restrictive wording of the BoC in its statement would cement interest rate expectations for July and support the CAD, though. 

USDCAD still trades in a broad 10 figure upward channel from 2017/2018. The end of April and most of May saw the cross consolidate around 1.28 with a mild upward bias. At time of writing prices are testing recent highs above 1.300, but candle patterns suggest the move is unconvincing. The momentum from the upswing could squeeze prices towards the March high of 1.3125 and the 61% Fibo of the 2017 decline at 1.3130.

Retracements lower will find interim support from the 55 and 13 mda lines around 1.2825/1.2850 with deeper support at 1.2720/25.

At the current juncture, I see little impetus to assume risk, but will watch closely dips towards 1.2800 for intraday buying opportunities. To the upside moves to 1.3130 offer decent selling opportunities.