FX Markets- European Banks, Italian Referandum and Widening Basis
In the wake of further weakness in bank shares, Eurozone peripheral government bonds took another battering yesterday, with 10yr PGB spreads over Bunds widening a further 6bp. Italy continued its underperformance against Spain, causing the 10yr BTP/Bono spread to break through 30bp – the level at which we suggested to fade out of Spain. Interestingly, DBRS, which placed its A (low) rating for Italy under review with negative implications outside of the indicated calendar on August 5, stated that it wouldn’t take any “knee jerk” reaction in the event of a “no” vote in the Italian referendum. With a notable German lender under the microscope due to concerns about capital adequacy in light of potential fines and related problems, European equities and credit have come under a degree of pressure. This has spilled over to some extent to the FX market via a widening of the EUR basis. Historically, banking crises and widening basis would have quickly led to a weaker EUR and much higher realized and implied volatility. But so far, the latest stresses have had almost no discernible impact on these vol metrics despite starting points that were already very low. We think this is a consequence of three main factors, namely the ECB’s improved ability to respond to systemic liquidity crises, a broad perception that German government authorities would likely prevent a large bank failure, and the more supportive BOP picture. In this context, we take a relatively benign view of these events and maintain our EURUSD 1.15 three-month target.
The other potential source of stress in FX markets is the US election and the risk of “Trumpxit”. So far however, this risk has been very localized, with MXN bearing the brunt of the impact of the rise in US political risk. In the aftermath of the rebound triggered by what was viewed as a “win” by Democratic candidate Hillary Clinton in the first presidential debate, the peso now faces an important test with the Banxico rate decision on Thursday, 29 September.