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Categorized | Currencies, Equities

Scary movie sequel beckons for eurozone markets


Posted on November 30, 2016

Just as horror movies can spook fright nerds more than they expect, so political risk is sparking heightened levels of anxiety among seasoned investors.

Investors caught out by Brexit and Donald Trump are making better preparations for political risk in Europe, plotting a route to the exit door if the unfolding story of French, German and Dutch elections poses a serious test for markets.

One key measure of risk aversion is the relationship between the bond yields of Germany and periphery countries. The difference between Italian and German bond yields has been widening as investors cast a nervous glance towards the first big political risk event, Sunday’s constitutional referendum in Italy, while the euro is under sustained pressure.

The European Central Bank’s trade-weighted euro index has slipped to its lowest level since March, thanks mainly to a post-US election fall of 4 per cent against the dollar.

The prospect of pro-growth polices under president-elect Donald Trump accounts for much of that slide, driving investors to buy the dollar. However Europe can play its own part in pushing euro-dollar to where several analysts now expect it to go — parity and beyond.

“If political risks do materialise, the downside for the euro is a lot more substantial than generally appreciated,” says Adam Cole, G10 FX strategist at RBC Capital Markets.

Not all share that view and think investors are worrying unduly.

After Brexit and Trump political risk looks more unreadable than ever, but there is a danger the market gets paranoid about the risk of European populists sweeping to power in 2017.

Investors scarred by pollsters misreading Brexit and Trump could hardly be blamed for fearing that the anti-establishment tide is coming Europe’s away.

“Anxiety will increase and market volatility will surely move higher ahead of these elections,” says Patrick Moonen of Dutch-based asset manager NN Investment Partners.

Volatility is already here. The euro rose almost 1 per cent early Monday in response to polls showing that François Fillon, winner of the centre-right primary to contest next year’s French presidential elections, would beat the National Front’s Marine Le Pen comfortably in a run-off.

The euro’s gain was then reversed at “breathtaking” speed, says Marc Chandler at Brown Brothers Harriman — proof, he says, that “the bearish sentiment toward the single currency remains intact”.

Still, the European version of political risk is complex, says Bilal Hafeez, FX strategist at Nomura. Tempting though it is to liken these upcoming events to Brexit or Trump, “the nature of the euro area political system is such that those types of outcomes are less likely”, he says.

A move through euro-dollar parity requires significant negative political news in Europe or a material surge higher in US Treasury yields, suggests Roger Hallam, currency portfolio investment officer at JPMorgan Asset Management.

Yes, investors are “absolutely focused” on European politics, he says, but he doubts a No vote in Sunday’s referendum represents an earthquake for Europe (“it’s more of a status quo”), while he considers a Le Pen victory a low probability.

None of this is a comfortable place for European Central Bank president Mario Draghi, who can add the US election outcome to the list of challenges he already faces.

With its current round of bond purchases set to end in March, the ECB is expected to unveil the third leg of its quantitative easing strategy at its council meeting next week. But then what?

Though a weaker euro at face value helps boost inflation and growth, policymakers must balance that against concerns Mr Trump’s win triggers a wave of protectionism that prevents eurozone exporters from reaping the gains of stronger US growth.

The recent rise of governments’ borrowing costs in the eurozone is also a concern. Their task is further complicated by the Italian referendum, with a No vote likely to trigger a further rise in Rome’s borrowing costs.

The ECB appears to be bracing itself for that outcome. Yields on Italy’s benchmark 10-year bonds fell on Tuesday on market speculation that the central bank was ready to speed up Italian government debt purchases in an effort to calm market nerves.

Policymakers cannot determine the outcome of European political events, but at least they can try to prepare investors for them.

Mr Hallam thinks policymakers will find investors receptive. “There’s a general sense around European political risk that we’ve watched this movie twice before and we were twice surprised at the ending, so let’s not have it happen a third time,” he says.